Looking For Macro Policy's Sweet Spot

How can both sides be right and wrong at the same time? Well, it's economics, for a start. And if we're talking of the dismal science, then timing is a factor too. No wonder that the debate about austerity, which has been called everything from "the greatest bait-and-switch in history" to the only path to enlightened policy because "spending cuts can improve both the budget and the economy."

Whatever you think about austerity, it's no academic issue. Just ask the Greeks, who are again under pressure to keep the big squeeze going. And in Britain, "austerity could last for another SEVEN years." The inclination to cut first and consider the effects on the street later has unleashed a "groundswell of anger" throughout Europe.

Opinions are passionately divided, but surely there's a clear path for sorting out who's wrong, who's right, and how and when to tell the difference. Actually, it's not that easy if you consider what's at stake today and tomorrow.

Let's start with economist James Hamilton's remark that "the more you borrow, the more you'll pay." An irrefutable truism, of course, and one with potentially troubling headwinds down the road for the US economy given the current state of macro these days. As Hamilton explains, we're nearing a critical juncture as US net federal debt as a percent of GDP moves closer to 100% (we're currently approaching 80%). To understand why this matters, a bit of history is required, Hamilton notes:

Consider for example the historical episode over the last two generations for which the U.S. was most successful in bringing its debt load down, namely the 8 years when Clinton was president (1993-2000). Over this period, the primary surplus averaged 2.1% of GDP. Given Clinton's starting debt load of 49%, those primary surpluses were big enough to bring debt down to 35% by 2000. But if Clinton had started out with debt at 100%, and had exactly the same success with raising tax revenues and reducing non-interest spending relative to GDP, the numbers just discussed could mean that those same policies would have accomplished nothing in terms of reducing the debt burden. Moreover, if we let debt get to 100% of GDP, we'd have to repeat Clinton's success decade after decade forever just to hold debt constant at 100% of GDP.

The bottom line: "If we start with debt at 100% of GDP instead of 50%, we have to run that much faster just to stay in the same place," he writes. But there's an extra burden these days because "we're going to be running the race with a bigger fraction of the population in retirement and with much higher medical costs than under Clinton."

The case for budget cutting, it seems, is self evident. Yes, but with complicating factors, namely, a sluggish recovery (still) after the Great Recession. Without slipping too far into the weeds here, let's just say that monetary policy is still the key variable, as economist David Beckworth reminds. How do we know? The relatively austere conditions in the Euro Area vs. the looser policy in the US are one clue, as implied by two rather distinct histories in recent years, as shown by changes in nominal GDP (NGDP):

Fiscal and monetary policy are two different animals, of course, but to the extent that austerity dominates the former, monetary policy must pick up the slack to maintain equilibrium.

But there's no free lunch. The Fed's quantitative easing program can't go on forever. Yet as Beckworth points out, ending it tomorrow would probably bring economic troubles. "It is not hard to imagine how much higher U.S. unemployment would be were it not for the Fed's QE programs," he advises. In turn, "critics who see the slow recovery and point to the Fed's [large scale asset programs] simply are not doing the right (if any) counterfactual."

The real challenge is figuring out how and when to start winding down the Fed's monetary stimulus in an optimal way—not too fast, not too slow; not too soon, not too late. It's not clear that this change should arrive in one fell swoop, but winding it down is still a big risk factor. There's a strong case for assuming that removing monetary stimulus should be gradual, a pace that reflects the evolving outlook for economic growth. In theory, this is all quite clear; in practice, it's a transition that's riddled with uncertainty in real time, in part because precedent on this front is largely MIA, at least on the scale that confronts US policymakers.

It doesn't help that both sides in this debate have a habit of talking past one another. But austerity and stimulus are intimately linked. You can't speak intelligently about one without the other. The dark art of deciding where and how when one ends and the other begins is the real front line for macro policy these days. It's easier, of course, to focus on one side or the other. But as usual in economics, reality is far more complicated.