Nonsense on the Deficit Question

by: Robert P. Murphy

In a recent piece I reported the shocking ignorance in a Huffington Post article on the alleged harmlessness of the federal deficit. Several readers wrote to tell me that as bad as the HuffPo article was, James Galbraith’s interview with Ezra Klein was even worse.

They were right. In today’s piece I’ll walk through some of Galbraith’s biggest whoppers.

What’s the Danger of Deficits?

Right out of the chute, Galbraith pulls no punches:

[Ezra Klein]: You think the danger posed by the long-term deficit is overstated by most economists and economic commentators.

[James Galbraith]: No, I think the danger is zero. It’s not overstated. It’s completely misstated.

EK: Why?

JG: What is the nature of the danger? The only possible answer is that this larger deficit would cause a rise in the interest rate. Well, if the markets thought that was a serious risk, the rate on 20-year treasury bonds wouldn’t be 4 percent and change now. If the markets thought that the interest rate would be forced up by funding difficulties 10 year[s] from now, it would show up in the 20-year rate. That rate has actually been coming down in the wake of the European crisis.

So there are two possibilities here. One is the theory is wrong. The other is that the market isn’t rational. And if the market isn’t rational, there’s no point in designing policy to accommodate the markets because you can’t accommodate an irrational entity.

Wow! Now I’m not too familiar with James Galbraith (son of John Kenneth Galbraith), so I don’t know if he is always this flippant. For all I know, he had had a few cocktails before talking with Ezra Klein. I will assume for the sake of argument that he sincerely holds the views expressed in this interview, and will answer them accordingly.

If nothing else, Galbraith’s glib response shows the problem with free-market analyses that don’t get to the core issues. It is certainly true that students in an introductory economics course will learn that the downside of government deficits is “crowding out,” which occurs when government borrowing pushes up interest rates and leads private-sector businesses to reduce their spending on investment. In a related vein, it is also true that many “right-wing” financial pundits write of the “fiscal discipline” imposed by the bond markets on profligate governments.

There is nothing wrong with these sentiments, but there is a danger in making them the case against government deficits. For in times like these, when the government runs trillion-dollar-plus deficits amidst record-low interest rates, the opponents of big government have no leg to stand on. They are reduced to warning of an impending jump in interest rates any day now, a view with which Paul Krugman has been having a field day.

Contrary to Galbraith’s claim, huge government deficits are dangerous regardless of the level of interest rates. In the first place, taxpayers are still on the hook for the federal debt, with or without massive finance charges. And yet Galbraith acts as if adding trillions of dollars to the federal debt carries no strings at all.

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Reposted from Mises Economics Blog