...against fictions and other tall tales

Monday, 31 December 2012

Evsey Domar's "On Deficits and Debt": A survival guide for making sense of today's economic challenges

As I look back to 2012, I'm reminded about how relevant the work of economist Evsey Domar, the late Professor of Economics at MIT and previously a Federal Reserve staff economist, is for making sense of the predicament facing the US and the world economies today.  Three news stories during the last year provided a good backdrop for presenting Domar’s views on public debt, budget deficits and economic growth.

First, there was the surprising about face during the summer months when European leaders switched from advocating austerity to voicing their support for actions that promote growth.  Professor Domar would have most likely approved of this change of heart by Europe’s ruling elite given that, many decades ago, Domar authored “The Burden of the Debt and National Income” (1944), a paper which argues that “the problem of the burden of the debt is a problem of achieving a growing national income” rather than one associated with the size of the budget deficit or national debt.

E. Domar
Specifically, in his paper, Domar demonstrated that, in the long run, the ratio of debt to GDP will gradually approach the ratio of the fraction of GDP borrowed each year to the rate of growth of GDP.  So, for instance, the US federal government borrowed approximately 7 percent of GDP in 2012.  If the borrowing continued at the same rate and the GDP (in money terms) grows at 2 percent per year, the ratio of debt to GDP will approach 3.5; with a 3 percent growth, it will be 2.3.

Thus, Domar showed that "less attention should be devoted to the problem of the debt and more to finding ways of achieving a growing national income" (1945:415)

According to Domar, attempting to reduce the public debt by cutting government expenditures (thus removing a significant source of income and growth from the economy) is largely self-defeating and exactly the wrong course of action if undertaken when the economy is struggling.

Then, in the fall, there was the debate among economists and bloggers about the intergenerational burden of the public debt.  Had he been around, Professor Domar would have probably been disappointed to learn that issues addressed (and, for many, put to rest) decades ago are still being debated.

And now we're facing the so-called ‘fiscal cliff’, a metaphor depicting the slowdown facing the US economy as a result of the expiry of tax breaks enacted at a time when the US federal fiscal budget situation was in better shape.  In the face of such a situation, Domar would have understood that the last thing policymakers should do when the economy is weak is to increase taxes which take away purchasing power from the economy.

As we enter a New Year, it is worth remembering Domar’s views on these and other related issues.  And nowhere are these matters best addressed than in his short, three-page article “On Deficits and Debt” published in 1993.  In this article, Domar challenges many of the widely held beliefs about debt and deficits. 

First, the article begins by taking on the popular view that considers the US federal government debt as analogous to household debt:
Our old puritanical injunctions against running into debt remain valid when applied to a private person. He or she can disregard them only at his or her peril.  A large corporation has more leeway: it can borrow by issuing bonds, and replace them with new ones when they fall due. If many large corporations simultaneously decided to pay off their debts, our economy would collapse: it is based on credit, the inverse of debt. Still any corporation, however large can go bankrupt...But, the Federal government is in a class by itself: so long as its debt is expressed in dollars (which fortunately is the case), it can always print as many dollars as it needs to pay the interest, though nowadays it would issue bonds, sell them in the market and, if necessary, have the Federal Reserve repurchase them. The Federal government, the creator of the Federal Reserve System, is its own banker.
Then, Domar describes the merits of a budget deficit:
By definition, a budget deficit means that the government spends more money then it receives, or, in other words, that it creates more purchasing power by its expenditures than it destroys through taxes.  Is this good or bad? It depends. If the economy is working to capacity, the creation of extra purchasing power will do little good and much harm: it will cause an inflation, which is easy to start and hard to stop. But when the economy has plenty of unused resources, the additional purchasing power is welcome. At such a time, we should rebuild our physical infrastructure, improve our education, health, and environment, and intensify our scientific and industrial research efforts, without raising taxes and without reducing or eliminating other needed services, always keeping a watchful eye on economic barometers to make sure that we do not overdo it.
All this sounds nice and easy, perhaps too easy to avoid suspicion. Are we to get something for nothing, as the old saying goes? Is there such a thing as a free lunch, after all? The offer of a free lunch is strictly temporary; it lasts only so long as unused resources, and particularly unemployed labor, are available, because they can be put to use with little, if any, social cost. But one they are gone government expenditures, however, desirable, must be matched with revenue.
Later in the article, Domar explains that the true burden of the national debt is distributional in that it involves a transfer of resources from one group to another group within the economy:
Some early proponents of fiscal policy argued that the size of the debt and of interest payments on it are not important because “ we owe it to ourselves”...There is some truth in this argument, but it should not be exaggerated. Even if all the Federal bonds were owned by Americans and all interest on the debt received by them, problems created by the existence of a large debt and by the need to transfer [billions of dollars] from the taxpayers to the bondholders would remain...
On the other hand, this does not mean that the...interest paid on the debt represents a net loss to the country...[T]hat interest go to other Americans, directly or not and that much of it is subject to Federal income taxes. President Eisenhower, who disliked deficits and debts, is reported to have said, shortly before he left the White House, that every American baby born at the time carried on its neck a tag indicating its share of the Federal debt. Perhaps it did; but it must have also borne a second tag showing its share of the value of the Federal bonds.
The article then presents some interesting views about whether the country’s ratio of debt to GDP is an appropriate indicator of the state of the economy:
Does the ratio of the debt to GNP matter? Yes, it does. Other things being equal, I would prefer a smaller rather than larger ratio...Other things are not equal. There are times and conditions calling for a deficit. Without it, unemployment may rise and the GNP may fall, thus raising, rather than lowering the debt burden.
The article concludes with a comment on how to best address the “debt problem”:
The proper solution of the debt problem lies not in tying ourselves into a financial straight-jacket, but in achieving faster growth of the GNP, a result which is, of course, desirable by itself. To the Republican and other politicians who are hell-bent on reducing the deficit and even repaying the debt, I would like to address a very short and simple question: Why? Are we suffering from an excess of purchasing power now?
As we head into the New Year and get ready to face many of the same concerns as in 2012, I think it would be a good idea to keep in mind these points.

On that note, I wish all readers of this blog a very Happy New Year!

UPDATE: The third paragraph was revised on January 12, 2013.  It originally indicated that Domar demonstrated in his 1944 paper that the ratio of deficit to GDP would equal the ratio of the fraction of GDP borrowed each year to the rate of growth of the economy.  Rather, Domar focused on the ratio of debt to GDP.  I also added a subsequent paragraph (after paragraph 3) which includes a reference to Domar's article "The Burden of the Debt: A Rejoinder" (1945).

References

Domar, E., "The Burden of the Debt and the National Income", American Economic Review, 34(4), December 1944

Domar, E., "The Burden of the Debt: A Rejoinder", American Economic Review, 35(3), June 1945, pp. 414-418.

Domar, E., "On Deficits and Debt", American Journal of Economics and Sociology, 52(4), October 1993, 475-478.

12 comments:

  1. A very good piece, not only for the substance but for having highlighted a great mind: Domar! too often forgotten by the op-generation, yet a mind who parlayed with the best, and was among the best.

    So you'll welcome the following from another great and honest thinker out of D.C.: http://www.imf.org/external/pubs/cat/longres.aspx?sk=40200.0

    A few of your readers were onto this, and other greats were already there, but the optics in some places take a while to calibrate when the sea gets rough, and there's a bad captain 'sur le navire'. Some people think that commanding a vessel on a river is a credential for commanding a vessel in the ocean during a squall. Lucky the captain had a courageous first officer and crew.

    Have another great year, circuit!

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  2. Thanks - I've been meaning to do a write-up on Domar all year. I realized it was best to sum-up the year with a piece on his thoughts.

    Thanks also for linking the paper on fiscal multipliers. It's the full analysis to the snippet that was released in the Fund's October 2012 Economic Outlook. I agree: good thing the ship had a good first officer and crew. Regarding the latter, I've been following Dan Leigh's work for a few years now. He's very good. Nothing beats an empirically-minded researcher when it comes to these issues. Another analysis by Blanchard on fiscal multipliers that I quite liked was Blanchard/Perotti 2002 "An empirical characterization..." Of course, this most recent one brings into play the impact of fiscal adjustments/consolidation.

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  3. There you have it, circuit. Another classic article uncovered. Great start to the year!

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  4. I'm not surprised that you inserted Domar into your narrative. Most would have that seminal mind at the beginning of a trope; but your work is like a vortex. You started with the contemporary narrative's broad picture and, over time refined it brilliantly to its origins, to its singularity. An amazingly interesting approach to filtering the nonsense and rubbish out. One is left with the critical core of the trope. There really ain't much new under the sun. Circuit, it's been a great pleasure watching the parse. I've watched you sail out and sail close to shore; you command both efforts well. This Domar piece is a gem! I read your columns and relive the creative vitality of the community that was, and hopefully will be.

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  5. @ GC: Thanks - There's so much information out there that I thought Domar's piece might save FRB readers some time: it sums up perfectly the problems we're facing (economic and political facets) and the proper way to address them. Also, I find it important to highlight the seminal works. It's the only way to make sense of the many viewpoints and beliefs in economics these days.

    As for the future of the discipline, I'm actually quite optimistic. For instance, six or seven years ago, my friends with MBAs would cringe when I said deficit spending has its purpose. Today, many of them are avid readers of Paul Krugman and have become much more sensible in terms of their views on economics and economic policy. (Although, the excellent post-crisis commentaries of Paul McCulley probably had something to do with this shift in mindset!) Also, I suspect more and more people will realize that there "ain't much new under the sun". As you say, much of it is there already.

    @Manfredo: Thanks for your note on Prof Buchanan. He's what the French call an "incontournable". The study of public finance wouldn't be the same (as enjoyable) without his contribution. As a footnote, I'm actually a product of public choice theory. As a student, I spent countless hours reading the likes of Buchanan and Niskanen (my favorite topics then were fiscal federalism and bureaucratic behavior). Ever read McCloskey's essay on Buchanan "Better than Plowing"? It ends with a discussion about Buchanan's "mature ability to hold two perspectives". I always thought that was interesting. I figured it explained his interest in both economics and political science, two disciplines that (let's face it) tend not to co-mingle all that much.

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  6. "Specifically, in his paper, Domar demonstrated that, in the long run, the ratio of debt to GDP will gradually approach the ratio of the fraction of GDP borrowed each year to the rate of growth of GDP. So, for instance, if growth in the US were to be 2 percent of GDP annually (and remain at that level), the current federal deficit of 7 percent of GDP would in time approach 3.5 percent. "

    Domar talks of the debt/gdp ratio but you seem to infer the long-run deficit/gdp ratio from his analysis.

    Ok let's do the maths!

    If 7% is the annual deficit and the growth rate is 2%, then according to Domar, the debt/gdp ratio is

    7%/2% = 350%

    Not sure where you get 3.5% from!

    But Domar is wrong as well, having treated the deficit as exogenously given. The correct analysis is by Wynne Godley:

    http://www.concertedaction.com/2013/01/05/wynne-godley-and-the-dynamics-of-deficits-and-debts/

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    1. Ram: I don't see a problem with what I wrote. But you should know that the proper way to express the ratio above is 7:2, which equates to 7/2 = 3.5

      Domar's basic point is that the ratio of the debt to national income is a direct function of the fraction of income borrowed and an inverse function of the income's rate of growth.

      As for the second point, I doubt that Godley would have thought his explanation somehow refutes Domar's basic argument that fiscal sustainability is ultimately about economic growth, not the level of public debt specifically.

      There's no basis at all to claim that Domar is wrong. Instead, in your post, you should simply state that increased growth may increase import leakage, which could then affect the government's ability to achieve a given level of deficit spending each year. As far as I'm concerned, the Godley and Domar viewpoints are separate and complementary, not opposing.

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    2. " don't see a problem with what I wrote. But you should know that the proper way to express the ratio above is 7:2, which equates to 7/2 = 3.5 "

      Your error is a simple mathematical one.

      7%/2% = (7/100)/(2/100) = 3.5 = 350%

      NOT 3.5% as you claim. 3.5% is 3.5/100

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    3. Thanks - I corrected the third paragraph and added an update explaining the changes.

      I also want to highlight this fantastic quote from the final paragraph of Domar's 1944 paper:

      "When post-war fiscal policy is discussed, the public debt and its burden loom in the eyes of many economists and laymen as the greatest obstacle to all good things on earth. The remedy suggested is always the reduction of the absolute size of the debt or at least the prevention of its further growth. If all the people and organizations who work and study, write articles and make speeches, worry and spend sleepless nights-all because of fear of the debt-could forget about it for a while and spend even half their efforts trying to find ways of achieving a growing national income, their contribution to the benefit and welfare of humanity-and to the solution of the debt problem-would be immeasurable."

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  7. Is there really anything new hear, other than the redistribution of wealth..

    It is the classic Socialist death spire..

    I ax, how responsible is this statement ?

    "The proper solution of the debt problem lies not in tying ourselves into a financial straight-jacket, but in achieving faster growth of the GNP, a result which is, of course, desirable by itself. To the Republican and other politicians who are hell-bent on reducing the deficit and even repaying the debt, I would like to address a very short and simple question: Why? Are we suffering from an excess of purchasing power now?"

    The author is correctly suggesting a remedy to a budget deficit, but his mind fails him by not remembering the past events, which in fact, undermines his attempt to find a solution.

    Moreover, he is quick to dispatch, as meaningless the national debt which means less borrowing power and a greater propensity to bankruptcy.

    These types of arguments are advanced to ensure that government (we) continues to play a massive and significant role in people's lives.

    Please, remember that the bane of the modern man, is he can not function without a third party agent - the government unit. Our society has become so complex and vast, that without a third party provider, chaos would ensue. This indeed they are your First Responder.

    It is always a delight for me, how economic supporters of today's regime repackage their economic messages...It is quite appealing to the vast low information voter.

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    1. Hans, thanks for your comments. Apologies for the delay -- this blog is fairly low frequency and I can't comment everyday due to my work schedule.

      The first thing to highlight is that Domar denies the possibility of a government which issues its own currency to default involuntarily or 'go bankrupt'. This is mentioned in the excerpts above. As a result, Domar believes that such a government has the flexibility to increase growth using policy tools, including fiscal stimulus. In a nutshell, Domar believes that proper fiscal expansion has a better chance of getting economic activity back on track than attempts at cutting expenditures, which, according to Domar, only worsen the downturn. In another passage (in another paper), Domar finds highly questionable the claim of some economists that increased government spending is harmful to growth. There is indeed something counter-intuitive to this claim.

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  8. Thank you, Circuit, for your response...

    For, Mr Domar, it is little more than the classic liberal approach to a problem...If the first batch of money did not do the trick, then try a second, third, fourth, fifth and so on...It is called Eddie Money or for the left easy money...There are numerous examples of these failures (Argentina) but Mr Domar and his fellow travelers have a vested interest to ignore these vintage failures.

    Despite trillions of expenditures, the repeated call is for simply more and more...

    I have said this before, what the left does not understand or cares for, is history or economics...

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