There’s no economic constraint on the fiscal space available to fight the next recession
The next recession has not begun—and might not even be all that close at hand—but events where people are talking about the Next Recession have definitely started.
The event we co-sponsored last month on the next recession and essays from the panelists can be seen here. It’s worth checking out. A highlight was the keynote by Christina Romer, who served as the first chief economist for the Obama administration as it was taking office in the face of the Great Recession. Romer established a reputation as a firm advocate for fighting the recession with aggressive and sustained fiscal stimulus. In retrospect, her recommendations were clearly right, and if politics had let them win the day, tens of millions of Americans would have suffered far less in the past decade.
A conventional wisdom has emerged in recent years that an aggressive and sustained fiscal stimulus won’t be possible during the next recession. This argument is that the U.S. lacks the “fiscal space” needed to undertake this type of fiscal stimulus because its debt-to-GDP ratio is too high. During the first panel, a number of panelists and I made the case that this conventional wisdom is wrong; there is nothing to stop policymakers from undertaking needed fiscal stimulus during the next recession – except their own potential errors in judgment (this argument was also a theme of a paper I wrote for the event).
During her speech, Professor Romer made an argument that may have surprised some; she pointed to recent work she had done showing evidence that, in the past, high debt-to-GDP ratios really were associated with less-aggressive fiscal stimulus following financial crises. She pointed to this evidence for why she advocates reining in the growth of public debt as a key strategy for preparing for the next recession. She singled out the 2017 tax cut as a key example of what not to do when preparing for the next recession.
It would easy to think there was a disagreement between the evidence cited in Romer’s keynote about high debt-to-GDP ratios muffling fiscal stimulus and my own claim that the U.S. currently faces no shortage of fiscal space to fight the next recession. But, there really is no substantive disagreement here on the economics. What the Romer research finds is that in a large sample of rich countries, “policymakers’ ideas” are the key factor linking high debt-to-GDP ratios and the failure to provide fiscal stimulus following a debt crisis, rather than genuine economic constraints. Quoting directly from this paper:
Our primary goal in this paper is to understand why a country’s fiscal response to a crisis depends on it prior debt-to-GDP ratio. One possibility is that it reflects constraints imposed by market access… Alternatively, the link between the fiscal response to a crisis and a country’s debt-to-GDP ratio may reflect choices by the country or international organizations. For example, policymakers’ ideas may lead them to tighten fiscal policy after a crisis if the debt ratio is high, but not otherwise.
This distinction between market access and policymakers’ ideas is key. The classic case for why high debt-to-GDP ratios impede the ability to undertake fiscal stimulus hinges on market access—the fear being that stimulus will lead to rising interest rates which crowd-out any useful effect of the stimulus (or, in some cases even lead to a debt crisis). Restricted financial market access and crowding out based on spiking interest rates would represent genuine economic constraints on the fiscal space available to a country.
However, policymakers might just have ideas about debt—whether informed by evidence or not—that cause them to forego needed fiscal stimulus when debt to GDP ratios are high. This certainly better-describes the most recent episode in U.S. economic history, when the U.S. Congress undertook extraordinary austerity measures even as the economy remained clearly depressed and interest rates were at historic lows.
In the end, Romer finds that for the large sample of countries studied, the statistical analysis indicates that ideas matter more for driving countries away from undertaking needed fiscal stimulus when debt ratios are high:
This paper seeks to understand why the prior debt-to-GDP ratio appears to matter for the fiscal response to crises. We find that including direct measures of sovereign market access, such as long-term government bond rates or sovereign credit ratings, does not eliminate, or even greatly attenuate, the estimated impact of the debt-to-GDP ratio on the high-employment surplus following crises. This strongly suggests that the debt ratio does not matter simply through its impact on current market access or because it is a proxy for market access. Rather, an important part of why it matters appears to be through its impact on policymaker choices.
In disaggregated investigations, Romer finds that for the U.S., ideas have always been the key factor linking either fiscal stimulus or fiscal contraction to debt ratios and crisis response.
Finally, it is important to note that the Romer paper assesses episodes of financial crises or “financial distress,” not recessions per se. Financial distress and recession are not the same thing, so this research does not map perfectly onto thinking about the next recession. For example, the Romer data starts in 1967, yet the only episodes of “financial distress” identified for the United States are after 1985—despite the terrible early 1980s recession that saw the unemployment rate peak at 10.8 percent in 1982. Further, one episode of financial distress identified for the U.S. in this data occurred in 1998, a year when the economy grew rapidly and saw unemployment hit 4.4 percent. In short, “financial distress” is a different phenomenon than “recession” in this research.
The research presented by Romer during our keynote is incredibly valuable and clearly highlighted the most valuable preparation we can do before the next recession hits: educating our policymakers to think more sensibly about debt and recession-fighting—much like I argued in my original paper the event.