Fiscal expansion at full employment

Corrected to use actual as opposed to vaguely-recalled deficit figures.

Brad Delong seems to believe that the US should pursue fiscal expansion “even” at a time of full employment.  His argument is that this will raise the neutral real interest rate and provide the Fed more distance from the zero bound come the next recession.  He expresses this thought with very high confidence:

It would do so (ed note: help Fed) whether or not it raised output and employment today as long as it succeeded in raising the neutral interest rate–and if a large enough fiscal expansion does not raise the neutral interest rate, we do not understand the macroeconomy and should simply go home.

I have two thoughts about this. First, I don’t think macroeconomists are really in a position to talk about truths that are so secure that we must either accept them or retire. Guys have trotted out that view before and lived to regret it. A little humility around these issues is appropriate.

Second, I don’t agree with him.  Let’s say a recession is set to arrive three years from now. We don’t necessarily know that now, but that is just how things work out.  Say also that the Congress / Treasury raises the underlying fiscal deficit from 3 1/2% to 5 1/2% right now and then leaves it there. This steepens the path of the debt / GDP ratio by almost 2 percentage points a year. We can’t say precisely without knowing the relationship between nominal growth and nominal borrowing rates.  But there is a meaningful steepening.

The fiscal pulse coming out of this might last three years, followed either by a shift to neutrality or possibly even a bit of drag, if you believe in any Ricardian effects at all or spot anything to the debt fear mongers. So looking out three years from now, you have either had no effect on the equilibrium rate or have reduced it. Plus you have used up fiscal capacity to deal with the next recession, not just because the debt is higher but because it is on a steeper trajectory too.

It seems to me that to avoid this conclusion you would have to be extremely confident that Ricardian and confidence effects are zero or lean really hard on the idea of a safe asset shortage.  You would also have to be almost indifferent to the path of the debt / GDP ratio.  Maybe. But not certainly. I would guess improbably.

There is a broader issue here too. A lot of economists missed that the rules change when the economy enters liquidity trap. I suspect they are now missing the shift that occurs again when it exits, even if tentatively.  Part of this is perhaps a fear of being “inconsistent.” Hey, you were ok with deficits under Obama but not now under new guy.  Recognizing that the rules change with the ebb and flow of liquidity trap is just being aware. It is not being “inconsistent.” That this shift has twice coincided with a partisan political shift is, I think, an awkward coincidence.  (Zero snark intended.)  One related beauty of this perspective is that nobody will believe it. So if you do, figure out a way to act on it, rather than proclaiming it. It is unlikely to make you popular.

One retort to this argument might be that a properly-focused infrastructure spending program would raise the return on private investment and thereby help avoid liquidity trap irrespective of these Keynesian considerations. That is a valid argument, in my view. It also has nothing to do with whether the projects are financed with debt, taxes or spending cuts elsewhere.