Keynes, the economy, and the Democrats

 

July 30, 2021

By Paul Krugman, NYT. Opinion,

So Joe Biden appears to have his bipartisan infrastructure deal. Of course, progressives will be bitterly disappointed if that’s the end of the story. But it probably won’t be. In the end, Democrats will probably pass a second bill through reconciliation, adding several trillion dollars in “soft” investment — especially spending on children, which almost surely will have bigger economic payoffs than repairing roads and bridges, important as that is.

But today’s newsletter won’t be about legislative maneuvering. Instead, I want to talk about a funny thing that has happened to economic policy debate, detailed in a recent article by Jim Tankersley. Suddenly, Republicans have become Keynesians, while Democrats are talking about the supply side.

Traditionally, Democrats sought to justify big spending plans, like the Obama stimulus, by arguing that they were needed to boost demand in a weak economy. This was even true to a limited degree about the arguments made for the American Rescue Plan, the $1.9 trillion package Biden got enacted soon after taking office — although as its name suggests, the plan was pitched largely as disaster relief rather than as Keynesian stimulus.

Republicans, by contrast, derided Keynesian arguments. In the aftermath of the 2008 financial crisis, they called for cutting spending, not increasing it, buying fully into the doctrine of “expansionary austerity” — the claim that spending cuts would actually increase demand by inspiring confidence (or as I put it, they believed in the confidence fairy).

When justifying their own plans for tax cuts, Republicans generally didn’t argue that those cuts would increase demand. Instead, they invoked supposed supply-side effects: Reduced taxes, they claimed, would increase incentives to work and invest, expanding the economy’s potential. Democrats generally ridiculed these claims.

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For what it’s worth, the evidence suggests that Democrats were right and Republicans wrong on both counts. The case for expansionary austerity was overwhelmingly refuted by experience, especially in the euro area, while the Keynesian multiplier-type analysis was vindicated. Supply-side economics has yet to offer a single convincing success story; the underwhelming results of the 2017 Trump tax cut are just the latest entry in an unbroken record of failure.

But a funny thing has happened. Republicans are now warning that Biden’s spending plans will cause the economy to overheat, feeding inflation — which is basically a Keynesian position, although it’s being used to argue against government expenditure. I guess the confidence fairy has left the building. Or maybe G.O.P. economics is situational — Keynesian or not depending on which position can be used to argue against Democratic spending plans.

Democrats, on the other hand, are arguing that their spending plans, while partly about social justice, will also have positive supply-side effects, raising the economy’s long-run potential.

What can we say about these claims on each side?

Concerns that Biden’s long-term spending plans will pump up demand in an economy that we hope will already be more or less at full employment aren’t entirely silly. It is, however, important to bear three things in mind.

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First, while the numbers being talked about are big, they’re 10-year spending plans, so annual spending will be in the hundreds of billions, not trillions — and the U.S. economy is very big. Here’s the Congressional Budget Office’s projection of potential G.D.P. over the next decade:

It’s a big, big, big, big economy.FRED

That cumulates to $295 trillion over the next 10 years, so even $4 trillion of spending is only 1.3 percent of G.D.P.

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Second, the spending will be paid for with taxes to a considerable extent, so that net stimulus will be smaller than the headline numbers. It’s true that the pay-fors are likely to involve a lot of smoke and mirrors, and if that isn’t the most budget wonk thing I’ve ever written, I don’t know what is. Still, the “fiscal impulse” probably won’t be very big. And though we obviously don’t have details on most of what is likely to happen, we can look at the projected year-by-year deficit effects of the Biden budget proposal from earlier this year:

Not that stimulative.Office of Management and Budget

Even at its peak, this is a much smaller stimulus than the American Rescue Plan, which was around 8 percent of G.D.P.

Finally, there’s good reason to argue that the U.S. economy needs sustained fiscal stimulus, even at full employment. The argument for secular stagnation — persistent weakness of demand, so that interest rates are very low even in good times — remains strong. This prospect raises concerns about future economic management: The Fed probably won’t have enough room to cut rates to fight off future recessions. So some persistent deficit spending to give the Fed more room to act would actually be prudent.

In fact, I’ve said on a number of occasions that I’m concerned that Biden is being too fiscally responsible, that we could do with more deficit spending going forward than he seems to want.

Overall, then, the Republican case that Biden’s proposals are dangerously inflationary — while not as bad as some of what comes out of that party — is pretty weak.

What about supply-side economics, Democrat-style? Unlike Republicans, who have consistently promised economic miracles that never arrive, Democrats are being very cautious about their supply-side claims. Nonetheless, progressive economists believe that there will be large long-term payoffs to spending more on infrastructure, research and especially aid to children.

And they expect fairly quick results if the reconciliation bill includes “family-friendly” policies like paid parental leave and child care, which they believe would increase female participation in the paid work force. I suspect that most Americans have no idea how much we’ve fallen behind on that front relative to other advanced countries with policies that make it easier for mothers to maintain their careers:

Women not at (paid) work.OECD

So there’s a pretty good case that Democratic supply-side economics will actually work.

Anyway, the bottom line is that there has been a weird role reversal in how the parties talk about economic policy. Republicans have gone all Keynesian, while Democrats are talking about the supply side. However, only one of the parties seems to be making sense.

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