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We’re embarking on an unusual fiscal experiment: high deficit spending at low unemployment

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Various employers were represented at the 100,000 Opportunities Initiative Job Fair. (Michael S. Williamson/The Washington Post)

While there’s some question as to their forthcoming political strategy, President Trump and the Republicans have maintained that because of rising deficits and debt, we need to cut safety net and social insurance programs.

Now, they were the ones who significantly increased the national debt by financing their tax cut with deficit spending. So, to my friends across the aisle, I say: “If you’re so upset by all that red ink, then repeal the cuts on wealthy estates, multinational corporations, and high-end pass-through businesses. But you must be blocked from repairing the fiscal damage you’ve done on the backs of those least advantaged.”

But this all invokes an interesting economic/fiscal question: Should we be upset by all this red budget ink? (For the record, the Republicans are not really upset; they’re pretending; see Corker, Bob.) As I wrote on this page, our deficit debate is almost always confusing and frustrating. That’s because the answer to the question, “Is the deficit too high?” is situational. It most importantly depends on economic conditions, and in that regard, we’re wading into unusual fiscal waters.

The figure below tells the story dramatically (it’s by Alec Phillips of Goldman Sachs/Research). The figure is a little tricky, because the unemployment rate is inverted, meaning when the line goes up, unemployment’s going down. The reason to do it that way is to show how closely linked the jobless rate usually is with the other line in the picture: the budget deficit as a share of GDP.


Source: Alec Phillips, GS Research

These are both highly cyclical variables. When unemployment goes up a lot, the deficit tends to go up as well, as various “countercyclical” spending programs kick in, while tax revenue take a hit. So, outside of wars, when deficit spending goes up for noneconomic reasons, the two lines hug each other pretty tightly.

Until recently. The timing of the tax cuts is such that they’re throwing a lot of fiscal stimulus—hundreds of billions in new, deficit spending—at an economy that’s already, on its own, closing in on full employment. Based on the already strong, negative trend in the unemployment rate, and the added stimulus, the unemployment rate could be in the mid-3s by the end of this year (it’s currently 4.1 percent). That’s a jobless rate we haven’t seen since the late 1960s.

As someone who constantly longs for very low unemployment, I welcome this development, should it come to pass. The tax cut is very poorly targeted; if I wanted to use the tax code to help those who’ve been left behind, I wouldn’t cut the estate tax. I’d significantly increase tax credits for low-income workers. But the Republicans, because they don’t care about the deficit when it comes to tax cuts, are engaging in an experiment that the more fiscally responsible Democrats would be unlikely to undertake: aggressive deficit spending at low unemployment.

How unusual is that? Well, looking at data back to the late 1940s, the average deficit-to-GDP ratio when unemployment was below 5 percent was close to zero. Since 1980, that same calculation yields an average deficit-to-GDP ratio of 0.5 percent. As I mentioned, the jobless rate this year may average less than 4 percent while the deficit-to-GDP ratio could be about the same, and closer to 5 percent next year. So, pretty unusual.

Again, I welcome the very low unemployment and don’t worry too much about economic overheating. And yet I still think there are reckless aspects to this fiscal policy.

First, there’s the targeting problem noted above. We’re wasting the fiscal stimulus on the wrong people.

Second, a good principle of fiscal policy is that when you hit full employment (we’re not there yet, but we’re close), your revenue take should be moving closer, not further away, from your spending. One reason that’s important is that there’s a recession out there somewhere, and you want the “fiscal space” to push back on it, which is a fancy way of saying Congress is more likely to administer discretionary fiscal policy in a recession when you enter it with a 40 percent debt-to-GDP ratio than an 80 percent ratio (this is a global tendency, as shown in a new paper by Christy and David Romer). That’s more political than economic — fiscal authorities should throw water on the fire even at high debt levels — but politics is dispositive in these cases.

This fiscal rationale is particularly important because there may well be too little “monetary space” when we hit the next downturn, meaning the interest rate controlled by the Federal Reserve might not be high enough to provide room for much monetary stimulus.

Third, as noted above, by locking in too few future revenue sources to meet our spending needs, the Republicans have purposefully set up this dynamic that feeds into their cut-spending, shrink-government agenda.

End of the day, if very low unemployment helps the recovery finally reach those who’ve heretofore been left behind, if it finally juices wage growth, which has been somewhat of a missing piece in this recovery, and if that happens without overheating and leading the Fed to slam on, rather than tap, the brakes, then that’s all good. But while all that’s going on, progressives must stand hard and fast against cuts to the safety net or social insurance. And we must not lose sight of our essential, longer-term goal of adequately funding the government to meet the needs of its people.

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