Mankiw and Ball on Deficits and National Debt
Here is a very good paper by Mankiw and Ball on budget deficits and the national debt.
The basics are great. Their conclusion is that budget deficits help current taxpayers and future capital owners while hurting future taxpayers and future workers. (For those of us who consider much of current government spending as a waste, and consider cutting that spending an option, the “benefits” to current taxpayers are largely an illusion.)
They also consider the “unlikely” possibility of a fiscal crisis–a sudden loss of confidence in the willingness of the government to pay its debts. This analysis is good as well, though they fail to consider an optimal monetary policy (nominal GDP targeting, of course.) Recent events in Europe are following the script they outlined in 1993 to a remarkable degree.
They express hope that developed country central banks would avoid inflation despite the fiscal crisis. I suppose this is what the European Central Bank is doing. With nominal GDP targeting, a loss of confidence in government debt would be inflationary in two ways. Most importantly, the drop in the exchange rate directly raises import prices, and unlike CPI targeting, import prices play no direct role in nominal GDP. Only as higher import prices (and exports) impact the demand for current output does nominal GDP tend to rise, requiring more restrictive monetary conditions to limit that growth to the target growth path. However, there is a limit to inflation from that source, with the prices of consumer goods rising to a higher level (or growth path) rather than growing at a permanently faster rate.
The other inflationary impact is due to changes in productive capacity. These have two elements, both discussed by Mankiw and Ball. The first is a shift from nontraded goods to traded goods. In other words, an expansion in the production of import-competing goods and exports. In the U.S. today that would be fewer restaurants and yoga lessons and more domestically produced cars and machine tools to be sent to China. Because these shifts take time, production and employment will be depressed. This is a temporary reduction in the productive capacity of the economy which with nominal GDP targeting results in a higher price level.
The second effect is more long run. The capital stock shifts to a lower growth path along with the productive capacity of the economy. This will also raise the price level with nominal GDP targeting.
These two factors imply a shift of the price level to a higher growth path. With a 3 percent growth rate for nominal GDP, the result is temporary inflation, with the inflation rate returning to approximately zero, but at a higher level. With a 5 percent growth rate for nominal GDP, inflation would accelerate for a time, but then return to the 2 percent trend.
Mankiw and Ball also discuss the possibility of a more general financial crisis. The real effects described above could result in bankruptcies for various firms and eventually result in bank failures. While they don’t say much about it, they hint at Bernanke’s view that it is a disruption of productivity enhancing financial intermediation that results in Depression. While I have my doubts about that, having the banking system closed down, or at least in the process of reorganization, would have some adverse impact on productive capacity too. (Figuring out a way to rapidly reorganize banks, with an emphasis on debt-equity swaps needs to be on the front burner.)
Interestingly, these impacts on the price level and inflation are harmful to foreign creditors. A nominal GDP target, therefore, may limit the ability of a government to borrow in the first place, (and shift more of the impact to capital accumulation.) While that is not necessarily a bad thing, a shift to nominal GDP targeting in the midst of a crisis might exacerbate capital flight.
Of course, the U.S. does not currently have a problem with “capital flight.” Still, I wonder to what degree keeping Chinese (and other foreign) creditors happy prevents the Federal Reserve and the rest of the Federal government from implementing nominal GDP targeting.
P.S. Mankiw and Ball are mainstream, new Keynesian, neo-classical economists. What, if anything, do my Austrian friends find wrong with their analysis of deficits and debt?