Should Plummeting Interest Rates Change Deficit Hawks' Arguments?

Dec 5, 2012Mike Konczal

Several deficit reduction plans came out at the end of 2010, including a proposal of the co-chairs of the Simpson-Bowles comission and another by Pete Domenici and Alice Rivlin. Since then, the economic recovery has been sluggish, with unemployment stubbornly high. The Republicans threatened what they called a "technical default" during the debt ceiling fight, a move which led to a ratings downgrade for the United States and months of subpar growth. Rather than balancing the budget, the deficit was 8.7 percent of GDP in 2011, and is projected to be 7.3 percent of GDP for 2012.

What else has happened? Borrowing costs for the United States have plummeted. While real interest rates for borrowing 10 years out were still positive in late 2010 when these plans came out, they have since gone negative and stayed there. Investors are paying us to borrow money for the next 10 years.

If you were concerned about our nation's deficits in late 2010 and you follow this crucial market signal, you should be significantly less worried now, right? It's important to note that this fall in our borrowing costs hasn't been incorporated into any of the debt discussion happening right now, discussions which still use frameworks created in 2010.

Take Version 2.0 of the Domenici-Rivlin Plan, released on Monday. Defenders argue that this plan calls for stimulus right away, and even has an "economic growth" checkbox in its slideshow to prevent immediate austerity. However, there are two big things in Version 2.0 that don't incorporate collapsing interest rates.

1. It Cuts Its Stimulus Plan by 80 Percent. When I brought this up on Twitter, several people noted that Version 2.0, much like Version 1.0, contains stimulus. However, it wasn't noted that it recommends significantly less stimulus in the second version, even though borrowing costs are significantly cheaper and getting to full employment is equally crucial for dealing with our deficits.

The first version recommends a payroll tax holiday of $650 billion. The new version calls for an income tax rebate of just $120 billion dollars (line 34). That's 80 percent less stimulus than in the original version, even though the price of providing stimulus has plummeted. Is getting to full employment suddenly less of a priority? We are still quite a ways away from there.

2. It Reuses "Down Payment" and Credibility Theories. A popular theory in 2010 was that any short-term stimulus needed to be paired with long-term deficit reduction. Why? Not for political reasons, like that being the only way to get either through Congress. It was because of strictly economic reasons. Without deficit reduction, the upfront stimulus would panic the financial markets, raising interest rates and canceling out the stimulus. (This ignores that rates would rise because the economy was getting stronger, but forget that.)

Here's Version 1.0, recommending "a short-term jump-start to growth and a commitment to long-term deficit reduction that makes stimulus credible." In Version 2.0 we get a similar claim: "Of course, this and any other policies that add to the short-term deficit should be paired with a long-term debt reduction agreement rather than be enacted in isolation." The authors also think that removing the fiscal cliff requires a "down payment" to satiate the markets for the time being.

Once again, it isn't clear what macroeconomic theory is animating the "of course" here other than a vague sense of credibility. To whatever extent that theory made sense in 2010, it's significantly less, ahem, credible now. The end of 2010 saw an increase in stimulus through extensions of the Bush tax cuts, unemployment insurance, and the payroll tax without any long-term deficit reduction, and there's no evidence it caused a market panic. Indeed, one of the sadder moments for President Obama's economic team was them walking through confidence fairy arguments during the debt ceiling fight in summer 2011, the logical end results of this credibility argument.

If we can pass stimulus right now, why don't we do it? Certainly Version 2.0 doesn't think Medicare changes must go with, say, their plans to adjust the COLA of Social Security. I'd say it's because making it clear that these are two separate issues with very different solutions keeps the Very Serious People from using manufactured short-term crises and mass unemployment to reengineer social insurance programs to do the things they want them to do. Regardless of whether you like those ideas, there's no reason to hold our current unemployed hostage in the process. And unfortunately for them, the capital markets for U.S. debt, one of the most liquid and transparent markets in the history of modern capitalism, agree. I'm still not hearing good reasons to ignore this big market movement from those still worried about the deficit as the major priority.

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