Alice Rivlin on Bracket Creep

In yesterday’s post on Alan Blinder and inflation-induced bracket creep, I promised to tell this story.

At the American Economic Association meetings in New York in December 1988, there was a session on economic policy and the economy. A number of major economists presented, but the two I remember clearly, because I asked them both questions, were Alice Rivlin and Joe Pechman. I’ve sometimes referred to Alice as “my favorite liberal economist” because she had a no-nonsense, clear-eyed view of things (although I think she never gave supply-side cuts in marginal tax rates their due.) But that was after I started following her work during the Clinton administration, when she was deputy director and then director of the Office of Management and Budget.

In her talk at the AEA meetings, Alice noted that there just hadn’t been nearly as much controversy about raising taxes to prevent major federal budget deficits in the late 1970s, when she was director of the Congressional Budget Office, as there had been from the mid-1980s to the year we were in, 1988. She stated it as if it were a puzzle. To me, it wasn’t a puzzle at all. So I stood up and asked the following (of course I’m going from memory here):

Dr. Rivlin,

You stated that there wasn’t nearly the controversy about raising taxes to reduce the deficit in the late 1970s as there is now, but isn’t there an obvious answer? Inflation in the last half of the 1970s averaged high single digits and the federal income tax brackets were not indexed for inflation. So inflation plus non-indexing assured that federal government revenues grew substantially every year, even without explicit legislated tax increases.

She answered, “Well, there’s that.”

When I had a chance to talk about this in my class when it was relevant to our discussion of bracket creep, I quoted her “Well, there’s that.”

Funny story: The next day after I quoted her in class, a sharp student caught me out on some important causal factor that I had left out of another discussion unrelated to bracket creep. I hesitated, thought through it, and then admitted his point. Another student piped up, “Well, there’s that.” We all got a good laugh.


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No free lunch for government debt

Matt Yglesias has a post advocating fiscal stimulus in the form of checks sent to all Americans. While discussing the bonds that would be issued to finance the increased deficit, Yglesias makes this claim:

The federal government needs to pay interest on the bonds, but that interest becomes Fed profits which are rebated to the Treasury so there’s no actual cost.

Of course, the total federal debt will go up, but the more important “debt held by the public” will not since the extra debt will, by law, be perpetually held by the Fed rather than by the public.

That would be true if the bonds were bought with zero interest currency notes, and the currency notes stayed in circulation forever.  Most of the debt, however, will be purchased with interest-bearing bank reserves.  This is because a large permanent increase in the stock of zero interest currency would likely cause the Fed to overshoot its 2% inflation target.  Maybe not right away, but certainly after the economy recovered and interest rates rose above zero.

So let’s assume that the deficit is financed by issuing Treasury debt, and the Fed buys the debt with interest-bearing bank reserves.  In that case, there is not likely to be much Fed profit to offset the interest burden on the Treasury.  Yes, the Fed will earn interest on the bonds it purchases, but it will pay interest on the bank reserves that it injects into the economy.

In general, the interest rate on bank reserves is roughly equal to the interest rate on T-bills.  While it is usually (but not always) the case that interest rate on bank reserves is below the interest rate on longer-term bonds, that sort of “profit” could be earned simply by shortening the maturity of the Treasury’s outstanding debt.  For various reasons, the Treasury prefers to borrow by issuing bonds of a wide range of maturities.  If the Fed bought longer-term bonds with bank reserves they would probably earn a profit, but there is risk involved.

It’s also possible that interest rates will stay at zero forever.  But in that case there would be no cost in financing the deficit even if the debt were not purchased by the Fed.  So money creation does not perform any fiscal miracles.

On the other hand, because the demand for currency rises over time, the Fed earns a certain amount of seignorage from adding to the stock of currency.  But that profit (sometimes referred to as the “inflation tax”), occurs regardless of what fiscal policy is doing.  And it’s a very small share of GDP, relative to the entire federal budget.

PS.  Some might argue that the US should copy Japan’s “zero interest rates forever” policy.  But Japan did not achieve that outcome with easy money; they did so by producing ultra-slow NGDP growth, which drove the Japanese natural rate of interest down to zero.  People who favor proposals to monetize debt and/or permanently hold interest rates at zero, are generally people who favor expansionary policies regarding aggregate demand.  Anyone in that camp should NOT be citing Japan, which among the major economies has the worst performing aggregate demand growth in modern history.  That’s why Japanese interest rates are stuck at zero.  Nonetheless, I recall seeing a few MMTers cite Japan as an example of a zero interest rate policy.


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Is stimulus costly?

With the seemingly endless stimulus now coming out of Washington, it’s time to revisit the question of whether deficits matter. In recent weeks, I’ve seen lots of pundits say that government spending is virtually costless, as interest rates are close to zero. There are two flaws with this argument.

Before getting into these flaws, let me acknowledge than many concerns regarding budget deficits are overstated. These big deficits are not likely to lead to high inflation, and they are not likely to lead to default on the debt. So what are the actual concerns?

1. Deficit spending always involves opportunity costs. That’s even true in a Keynesian model where deficit spending magically boosts output so much that it’s self-financing. Whenever you spend money on X, there’s always the opportunity cost of not spending it on Y.

Is the government’s best use of money to send people like me a check for $1200? It’s hard to imagine that the answer is yes, even if you believe (like me) that the government is not very good at wisely spending money. Consider this analogy. Imagine you are Ms. Bezos, and you’ve just come into a windfall of $50 billion. You decide to give a big chuck of the money to charity. Where do you donate the money?

It’s probably true that the average middle class resident of Seattle would benefit more from a $1200 check than Ms. Bezos, but is that really the best use of the money? I don’t know of any charity that randomly hands out checks to average people.

Even if you favor tax cuts as the preferred way of returning money to the public, giving almost everyone a $1200 check is not really a tax cut, it’s a (welfare) spending increase. A tax cut is when you lower the tax rates from which you derive the money in the first place.  Taxing people and giving part of the money back is a tax program combined with a spending program.  To argue otherwise is to argue that AFDC welfare and Social Security are “tax cuts”.

If we must run deficits, then they should be either in the form of cuts in tax rates or spending in areas where it has the greatest impact on human wellbeing.  And that’s probably not a huge bailout of the Post Office.

2. The second cost of budget deficits is the future tax burden they impose. Public finance theory suggests that the most efficient policy is one that smooths tax rates over time. Notice that even this criterion suggests that we should dramatically increase the budget deficit during wars and depressions. So right now it is appropriate to increase the budget deficit somewhat. (And we should have run a budget surplus in 2019, when the actual deficit was exploding upward.)

Nonetheless, it’s highly likely that the deficit this year will be too large, even from an optimal public finance perspective. I expect we’ll have to pay a price in terms of higher future taxes, perhaps not too far out in the future. Yes, higher future taxes were already on the way, for various reasons, but the current deficits will make the tax increases even greater than otherwise.

PS. I’m also seeing pundits suddenly claiming that unemployment insurance doesn’t discourage people from working. And yet even progressive bloggers like Brad DeLong and progressive textbook writers like Paul Krugman suggest just the opposite. If you make something more lucrative, you will get more of the activity that you are subsidizing.

I happen to believe that some expansion of unemployment insurance was appropriate during this pandemic, especially the provisions that covered a wider range of workers. But we shouldn’t pretend that this does not increase joblessness. And I don’t understand why unemployment was made so generous that it replaced more than 100% of lost wages. Can someone explain the logic of that to me?

The science of economics always regresses during a depression.  We saw that in the 1930s, in the 2010s, and we are seeing it again today.


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