"Deficits and debt don't matter, we owe it to ourselves; we should run as big a deficit as needed to get our country out of recession."
"International coordination of fiscal policy is needed to make sure each country runs a big enough deficit to get the world out of recession."
Your choice. One or the other. Not both. Which one do you want to believe?
Suppose Canada chooses its macroeconomic policy to be what's best for Canada, taking other countries' policies as given, and all other countries do the same. The result is called the Nash Equilibrium. Will the Nash Equilibrium be Pareto Optimal? In other words, would it be possible, in principle, to find a different set of policies which make all countries better off than in the Nash Equilibrium (or at least some countries better off and none worse off)?
If the Nash Equilibrium is optimal, so that each country pursuing its own selfish interest is lead by an invisible hand to do what is best for the world, then we don't need any international agreements. But if the Nash Equilibrium is not optimal, then the world could benefit from international policy coordination.
Starting at the Nash Equilibrium, small changes in one country's policy will cause very small harm to that country (analogy: if I am on the summit of a roundish hill, small steps away from the summit will cause very small changes in my elevation). If small changes in one countries policy which cause very small harm to that country can cause larger benefits to a second country, then the Nash Equilibrium will not be Pareto Optimal. If we all take steps which do a little harm to ourselves, but much more benefit to our neighbours, we are all better off. "You stimulate your economy a bit more, and we'll stimulate ours a bit more; deal?"
In normal times, when each country can use its own monetary policy to get the right level of aggregate demand, it is hard to see any significant benefits from international macroeconomic policy coordination. It is hard to see how Canada could benefit if the US had an overly tight monetary policy, which put the US economy into recession. And it is hard to see how Canada could benefit if the US adopted an overly loose monetary policy, which caused high US inflation. So in normal times, when each country uses its own monetary policy to choose what's right for it, what's good for each country is probably good for the world.
The reason for this result is that monetary policy is purely an instrument: we don't care what monetary policy we choose as long as it gets the right level of Aggregate Demand. If a change in US monetary policy affects Canadian AD, Canada just changes its own monetary policy to get AD back to where it wants it to be, with no loss or gain to Canada.
But if nominal interest rates fall to zero, and monetary policy hits the lower bound, countries have to resort to fiscal policy to influence AD. If we still believed Abba Lerner's doctrine of Functional Finance, then we would view fiscal policy, like monetary policy, as merely an instrument to get the right level of AD. If the US tightened its fiscal policy (cutting government expenditure or raising taxes), this would reduce AD in Canada (because US incomes would be lower, and the US exchange rate would depreciate, and for both those reasons Canadian net exports to the US would fall). But if AD fell, Canada could simply loosen its own fiscal policy to restore Canadian AD back to where Canada wants it, with no loss or gain to Canada.
If the doctrine of Functional Finance is correct, so that fiscal policy, like monetary policy, is merely an instrument for controlling AD, a means to an end, and not something we care about in its own right, then international coordination of fiscal policy during ZIRP is as unnecessary as international coordination of monetary policy in normal times. "You want us to loosen our fiscal policy to stimulate AD in your country; why don't you just loosen your own fiscal policy? (shrugs)."
But no country now believes in Functional Finance. Countries care about the burden of debt on future generations of taxpayers. The only people who don't believe in the debt burden, economists who believe in Ricardian Equivalence, also, and quite consistently, believe that deficits do not stimulate AD, so cannot believe in Functional Finance for that quite different reason. (Indeed it is proponents of Functional Finance who are inconsistent, wanting to believe both the Ricardian doctrine of no debt burden, and the Keynesian doctrine that deficits stimulate AD).
Wanting to stimulate AD, but not wanting too big a deficit and debt on future taxpayers, each country chooses a trade-off between the two, where it is equally concerned about the future debt burden from looser fiscal policy and the unemployment from tighter fiscal policy. That determines the Nash Equilibrium. Starting at the Nash Equilibrium, country A wants country B to loosen fiscal policy, which benefits A's unemployed and/or A's future taxpayers, at the expense of B's future taxpayers. And country B want the same of country A. Since, at a Nash Equilibrium, a small loosening of country A's fiscal policy will cause very small harm to country A, and bigger benefits to country B, the Nash Equilibrium is not Pareto Optimal. International fiscal policy coordination is needed.
International coordination of fiscal policy is needed only because nobody believes in Functional Finance.
Worthwhile Canadian Initiative 
Nick:
Centralized control of economies has never worked on a national scale, anywhere in the world. What makes you think it will work any better on a global scale?
The Nash equilibrium may not be Pareto optimal, but any result of centralized global economic control is bound to be worse — probably much, much worse — than the results obtained when each country simply takes care of its own interests.
commonsense: I had to go make a cup of tea while I thought about that.
Damn! I think you have a point.
If there were just two countries, then it’s a simple question of bilateral trade: “If I expand my deficit by x% of GDP, will you do the same?”. There’s no third party to enforce the trade, but at least it’s not illegal, so it should be easier to get to some Pareto Improving point than most drug deals.
But in an n country game, where n is large, it’s a public goods problem, and it’s not obvious they will agree and be able to enforce the agreement in a repeated game.
Free trade agreements eventually seem to get agreed, and stuck to, at least some of the time. But in free trade agreements, there’s a clear focal point for the optimal agreement: 0% tariffs. In the fiscal stimulus game, there’s no obvious focal point for the optimal agreement: x% deficits? What’s x going to be? And free trade agreements should last indefinitely, whereas stimulus agreements in a ZIRP should be short-duration, so repeated plays of the game are less likely to enforce the agreement.
I never paid much attention to the international macro policy coordination stuff before. It always seemed to be a solution in search of a problem; a bunch of politicians in a Swiss resort trying to think of something useful to talk about. But in ZIRP, the problem might be real, and coordination could improve things, at least in principle.
I think I’m going to fall back on an argument I have used a lot over my last 6 years as Associate Dean: “There are three ways to allocate resources: the market is first best, soviet central planning is second best, and the Hobbesian State of Nature is third best. Right now there is no market, so I’m acting as soviet central planner to get you lot out of the Hobbesian State of Nature!”
Nick:
I agree with the bulk of your reply, except the last bit.
Consider the countries where soviet-sytle central planning has been implemented; in particular, consider the quality of life of the average man in those countries. Those countries provide the best possible examples in support of my point.
I’ll take the Hobbesian State of Nature over the Marxian State of Slavery every time!
There is some space between “centralized control” and “coordination,” no?
Not if the politicians can help it…
commonsense: after thinking some more about your second comment, I have now revised my opinions. Sometimes the Hobbesian State of Nature will be better that Soviet Central Planning, and sometimes it won’t. For example, if the Nash/Hobbes equilibrium is very close to PO, then central planners could at best make small improvements or more likely make things a lot worse. If Nash/Hobbes is a long way from PO, then vice versa with central planning. But this is wandering off topic a bit.
I think ignorantmike has a good point. Let me re-phrase it another way: I now have serious doubts as to whether n independent countries could actually agree on and enforce a mutually beneficial trade on fiscal policy. But that isn’t the same as central planning, where the UN (say) has a big stick and forces every country to set the fiscal policy the UN wants. It’s exchange, not command and control.
Nick:
Yes, I agree: only if what you’re calling the Nash/Hobbes equilibrium is far from Pareto optimal does centralized action have any hope of bettering it — and then only temporarily.
This is because the nonlinear cooperative/competitive dynamics of the global economy will keep the aggregate operating point near the optimum most of the time, with high probability. And the expected deviations from the optimum get smaller and shorter with increasing number of players, whether or not they have any desire or ability to come to any explicit agreement. We don’t even assume that the players are independent — we explicitly acknowledge that they are interconnected in complex overlapping cooperating/competing networks. This dynamical regime is called self-organized criticality, and it is the objectively sound explanation of the phenomenon which is often referred to, in almost mystical terms, as “the invisible hand of the market.”
So the benefits of centralized action are likely to be small and transient, while on the other hand the price of centralized action is certain to be large and permanent.
The price, as you say, is to suffer the UN to have a big stick with which it forces every country to do what the UN wants. This is a very, very bad idea!
Power corrupts, and absolute power corrupts absolutely.
Much better to put up with a few market fluctuations.
commonsense: that was a very productive debate (for me at least). It’s clarified my thinking.
But I’m a little disappointed that nobody has challenged me on what I said about Functional Finance. Until about 25 years ago, this was received doctrine. Anyone who worried about the national debt (except for some small caveats), who didn’t understand that “we owe it to ourselves”, was deemed to be economically illiterate, or naive. I still remember a Carleton Economics seminar, where the visiting speaker (can’t remember who he was, but from some top US school) said “I assume everybody here is educated, and understands that the debt is not a burden”, then looked disdainfully around the room.
Anyone?
OK, I’ll bite: the debt is not a burden for any sovereign currency issuer in a floating exchange rate regime, and anyone who thinks it is is an ignoramous. It’s not a matter of “owing it to ourselves”: it that the whole concept of a currency issuer “owing” it’s own currency to anyone is conceptually flawed. In a functional finance regime, where government spending is kept at a level consistent with full employment, an increase in interest payments just means less necessity for other spending to maintain the proper level. And if interest payments, for whatever reason, are seen as being too high? Reduce the interest rate, to zero if necessary, across the yield curve. Again, all the talk about how deficits will “increase interest rates” is an artifact of limited understanding, or at least of being caught in the gold standard paradigm. The currency issuer only pays such interest as it sees fit to pay. Indeed, the only purpose of “borrowing” for a currency issuer is to support non-zero interest rates.
That what you were looking for?
It seems that there are quite a few people in Canada who support the free loader position for Canada in global stimulus coordination. Our government has committed to 2% of GDP stimulus in Peru, while in Ottawa is committed to balanced budgets (although I guess we’ll see in January–the balanced budget forecasts were based on very rosy assumptions).
We would probably freeload on the auto bailout as well if that wouldn’t mean the Canadian plants would be shut down regardless of productivity.
jimbo: that was better than I was looking for! If the government can finance a deficit at zero interest rates, then it can roll over the debt forever, and never have to raise taxes. The question is, can it finance at zero interest rates? In the current context it can (well, we’re not quite at 0% interest in Canada, but we’re close). The question is, though, how long will 0% interest last? Eventually we will come out of the recession, get back to normal, and the Bank of Canada will have to raise interest rates above 0% to prevent accelerating inflation.
There’s another way of looking at it: suppose the deficit is money-financed, rather than bond-financed? If so, then since money pays 0% interest, we don’t have to worry about the debt and future tax increases. I explored whether deficits would in fact be money-financed in an earlier post here: http://worthwhile.typepad.com/worthwhile_canadian_initi/2008/11/will-deficit-spending-in-fact-be-moneyfinanced.html . I concluded that they would in fact be at least partly money-financed. But if so, there’s no cost to running a deficit, and international coordination is not needed.
Andrew F: I think I agree.
“the Bank of Canada will have to raise interest rates above 0% to prevent accelerating inflation”
Well, this is the real crux of the matter, isn’t it? The belief in the all-powerful efficacy of interest rates to tame the inflationary beast is a hangover of the malevolent influence of Uncle Milty on modern economics. Fortunately, our present crisis shows signs of waking some economists out of their Friedmanite stupor. Put simply, I think an economy can move along quite swimmingly at 0 or near 0 interest rates essentially forever, with properly set tax rates to drain purchasing power when things heat up too much. Monetary policy has gotten way too much credit over the last 3 decades, especially since Volcker was credited with the taming of inflation that had much more to do with breaking the back of OPEC than his engineered recession.
Lerner’s functional finance approach is one of the most misunderstood topics in the Keynesian literature, mostly because people approach it through a gold-standard, hard money paradigm, when it emphatically about the possibilities that follow when you abandon that paradigm. Even Keynes himself never fully took the leap, although he came to grudgingly accept FF after prodding by Lerner.
Stephanie Bell and Matt Forstater have done the best modern work on FF and floating rate currencies. Here’s a good short paper from Bell that summarizes their approach: http://129.3.20.41/eps/mac/papers/0004/0004031.pdf
Did a little more searching, and here’s a more complete explanation of FF, including the importance of “state money” to the concept, from Matt Forstater: http://www.levy.org/pubs/wp272.pdf
Thanks jimbo: I will try to read those links.
I remember reading Abba Lerner’s FF about 20 years ago, and being very impressed. It was like one of those duck/rabbit gestalt switch things, where you could see it all through his eyes, oe see it through other eyes, but never quite see where the switch was.
Stepping back from the conflict for a bit, there is one thing that disturbs me (perhaps it’s what disturbs you too): it seemed like at one time everybody “knew” that the debt was not a burden, then a couple of years later (in the early 1980’s?) everybody “knew” that it was a burden, but nothing much really happened in the meantime that would justify the switch in received doctrine. I actually read Lerner’s FF, and Buchanan, and Barro, and several others, and wrote down lots of NPV formulae to try to get my head around it so that I was comfortable with my beliefs, and knew why I believed what I did. But I’m not sure how many other people did. It seemed to be more a change from one fashion to the next.
Yes, it is wierd, isn’t it? Me, even though I like to blame Friedman for it (mostly because I continue to be astounded that a hack like him, who was proven so wrong again and again, is still spoken of with reverence…) I have to say it has more to do with economists slipping back into the the old habits of thought (that Keynes warned were so difficult to dislodge) once there was the slightest excuse to do so. Of course, as a Post-Keynesian by inclination, I view the supposed postwar “Keynesian consensus” as mostly an attempt to build a new, improved Keynesian house on a rotten neoclassical foundation that was ultimately doomed to collapse. So take anything I say with that in mind…
The first statement doesn’t take a long enough timescale into account. Whoever decreed debt is excluded from GDP should be tasered. If I run a deficit of 10000x GDP, my country will get out of recession but I better think of a South American-ish new name for my country.
The question about doesn’t strike me as either-or. Running a deficit is not a given. To me the lowest hanging fruit is ensuring unemployment stays low. Running a deficit takes purchasing power away from future governments and gives it to who?? If you’re making younger Canadians work another year to retire, you need to ensure what you spend the money on sops up recession-unleashed unemployment.
Run a deficit (or don’t by freezing upper-tier income tax cuts or taxing carbon) if what you are spending the money on to create jobs now is “cheaper” than spending the money on whatever in the future. Where too much debt lowers credit ratings future PMs are being handcuffed and there are plenty of IMF-ed examples of what happens to such nations.
The Nash Equilibrium can’t be applied in a world with trading and migrating actors. If Canada levees a 10000x tarriff on Cuban cigars, Cuba won’t sit by idly. They will tax our Marijuana exports and we’ll get cancer and they’ll get diabetes.
“Running a deficit takes purchasing power away from future governments”
See, this is what I’m talking about. This is, at best, leftover thinking form a gold-standard paradigm. At worst, it’s an inability to see the difference between a currency issuer and a currency user. The Federal government of Canada (like any other currency issuer) does not have any financial limits whatsoever on it’s ability to spend. It does not have any more money available to it when it is in surplus than it has when it is in deficit. Operationally, it must spend the money into circulation BEFORE it can “borrow” it back. The only limits on its spending are the real limits of its effects on the economy (namely inflation, if it increases spending in the face of full employment and thus bids up the price of scarce resources)
Those who do not understand these basic realities of monetary operations are doomed to talk nonsense about public finance in particular, and economics in general.
jimbo, sure the government has limits. Taken to the extreme, a government that runs a deficit of 100000x of GDP will see hyper-inflation as you mention (a worker paying $100000 for a loaf of bread might notice this) or massive currency devaluation (where it is now Florida oranges that cost $100000 a bag). This has happened, mostly in the developing world where a dictator is in cahoots with a neocon western aid overseer.
Right now, going from surplus to deficit doesn’t matter to Canada’s credit rating, especially comparatively. But in 1993, when PCs had the country flirting with bankruptcy, increasing the deficit may further have decreased our credit rating. Everything the federal government bought since 1993 would cost a little more assuming no bankruptcy. A menial example, Canada sends MB transfer payments. MB recently bought 4 (I think) medical machines used for cancer. If Mulroney had gone even further into deficit, S.Harper may have only been able to send MB enough for 3 machines. In the future, we have medical costs projected to rise about $80B (this might be way off) annually by 2015, and Conservative corporate tax cuts drop from 22.12% to scheduled 15% is $10B annual is reduced revenue, so this may be an issue again.
lol, you really think debt doesn’t matter at any level and inflation is a minor concern?! What happens when people go into debt? Your cost of borrowing goes up and/or you go bankrupt and lose assets. This has happened to nations (esp. poor ones with mineral reserves) and will again. Just when do you think debt becomes an issue? Never? I’d agree with most people that Canada was in trouble around 1993. You don’t think any level of debt affects credit ratings or odds of bankruptcy? We should be okay with our mineral reserves even assuming dumb Conservative government, but if the USA continues to want big wars, low rich-income taxes, big cars, big homes…I think they might go bankrupt just like their international financial institutions have bankrupted many cold war strategic or mineral rich developing nations.
Once again, you miss the point. Even though rating agencies insist on doing them, the concept of a “credit rating” for a currency issuer in it’s own currency is simply incoherent. A credit rating is an attempt to rate an entity’s ability to pay its debts. But a currency issuer can ALWAYS pay it’s debts in it’s own currency, and at any interest rate it cares to pay. How could it be otherwise? The only way Canada can “default” in Canadian dollars is for it to refuse to honor it’s own checks. While that might be conceivable, it has nothing to do with “ability” to pay, only “willingness”. Japan, after the deficits of the late 90’s, had a credit rating lower than Botswana’s – and yet was able to “borrow” as many Yen as it wanted at a little over 0%.
“Poor nations with mineral reserves” have gone bankrupt, true – when they held debt in other nation’s currencies. What I am trying to get across is that you are confusing completely different situations when you compare, say, Canada owing $C and Argentina owing $US. They are completely different phenomena.
I see your point now Jimbo. But it still seems an pointless issue of the semantics of inflation vs devaluation. The issue is whether going into deficit erodes purchasing power and highlighting that it erodes only non $CD denominated purchases doesn’t change the argument (future cancer machines that would be lost by present deficits are made by Siemens or GE; is no Canadian manufacturer).
FWIW everyone mostly agrees with you that the threat of bankruptcy and higher interest rates can/should be ignored. I’m pretty silent on this as I generally like Obama’s suite of spending and stimulus as acceleration of democrat spending. Not much to say on this side of the border as coalition or government plans aren’t out yet and PM has ensured no government since May. Another salient downside risk is you initiate stimulus and it doesn’t occur until economy recovers and stimulus costs become unnecessarily high.
If Argentina owed debt denominated in domestic currency, you get devaluation instead of inflation. Same result, international financial institutions make you slash social programmes and you lose a generation. Countries pay interest rates on the deficits they run and these interest rates are not trivial considerations just because “we owe the money to ourselves”. Otherwise you could literally print out 100000x your GDP and own Earth. The reason your rhetoric fails is our currency would be rendered toilet paper. At some point civil unrest would toss those who have turned off the import taps. The credit rating is perhaps measuring this?