Krugman Versus Sachs

An entertaining spat has broken out between two famously liberal economists – Jeffrey Sachs and Paul Krugman – over the future of public spending. In Monday’s Financial Times, Sachs outed himself as a deficit hawk, dismissing government fiscal stimulus as an unnecessary part of the economic recovery. This drew predictable fire from Krugman, who when not making baffled cameo appearances in movies such as ‘Get Him to the Greek’ is now the official representative of John Maynard Keynes on earth, and continues to warn that stopping the stimulus when the economy is on life support (i.e. interest rates are at or near zero) risks tipping us back into recession.

While Sachs is right that public debts need to be tackled, history offers two cautionary tales about switching to deficit-reduction too early, which we discuss in The Road From Ruin. The most recent example was in the 1990s, when political paralysis and a culture of denial stopped Japan’s government from responding decisively to the stagnation in its economy, resulting in a ‘lost decade’ of zero growth. Happily, America is not there yet, though it will not be surprising if eventually it is, in a double- or triple-dip recession’s time.

When the Japanese economy did start to grow towards the end of the 1990s, it was tipped back into recession by a tax increase. But the situation in the US today has even stronger echoes of the mid-1930s, when FDR’s New Deal improvisations were finally starting to feed through into an economic recovery only to stall in 1937 as the result of an ill-judged premature fiscal squeeze. The mistake US policy makers made in the 1930s was believing too soon that they were out of the woods – an error that Sachs seems to be repeating today.

Sachs does, however, pose an important question -  when the time comes to cut, where should governments look for savings and where should they continue to invest public money to build a strong economy in the future? Krugman prefers not to answer this question, remaining faithful to his master’s edict that it is the spending itself that matters most, regardless of what it is on. (Keynes argued that the Treasury could do its job by burying bottles of banknotes and paying people to dig them up again – a policy that in today’s world, with confidence in government very low, might well make the economy not better but worse.) We believe that how the money is spent today is will make a potentially huge difference to what sort of economic recovery there is, and Sachs is right to argue that as much government spending as possible should be of the kind that can credibly be classified as ‘investment’.

That said, when it comes to the details of the deficit reduction he calls for, Sachs turns out to be wielding not an axe but a toothpick. (True, this is hardly a surprise, given Sachs has consistently championed more public spending on overseas aid.) Indeed, his plan is awash with spending commitments: education, welfare, healthcare, infrastructure, clean energy are all priorities for receiving more of the taxpayers’ dollar under Treasury Secretary Sachs. And it is noticeably silent on what he would cut.

We do not doubt that some of Sachs’ spending suggestions are sensible. Continuing to invest in education as the driver of the competitveness of rich (i.e. high-cost) economies is surely the right thing to do. (It is therefore baffling that the new UK government, for example, has made cuts in higher education part of their initial £6 billion ($9 billion) austerity package.)

So how would Sachs cut the deficit while protecting or increasing spending in these vital areas? By taxing the rich. While this might make populist sense it suffers from two problems. First, it’s impractical, at least on the scale that would presumably be needed to pay for the Sachs spending plan. The rich are notoriously difficult to tax, in part because they are internationally footloose, and can afford better accountants than the rest of us. Second, taxes on the rich too easily become taxes on wealth creation, which is the last thing, especially in these recessionary times, that any government should discourage, deliberately or by accident.

Again, consider the current situation in Britain, where the two parties in the new coalition government are fighting over whether to push capital gains tax up from 16% to match the top rate of income tax of 40%. Advocates of the increase are right to point out that there is something iniquitous in the situation that someone’s earnings from hard work are taxed at more than double the rate of someone making a killing off the sale of second home that has soared in value. On the other hand, that particular horse has surely bolted. In the coming decade, it seems highly unlikely that significant returns to capital will result from asset price bubbles rather than from innovation and industry – exactly the things our economies need most. Sachs’s proposal to ‘Tax the rich’, for all its obvious populist appeal, is almost as pointless an answer to the ‘how to cut the deficit?’ question as the usual politicians’ answer: cut waste.

Rather than looking at Sachs’ vacuous plan, a better guide to where the axe will eventually fall (as sooner or later it must) comes from the austerity measures that European countries have had forced on them prematurely by the flaws in the Eurozone (especially Greece). Sales tax and VAT increases are an attractive option – they are easy to collect, spread the pain broadly and do little harm to incentives. Cuts in public sector salaries are also a pretty fair way to reduce spending – civil servants’ job security and generous pensions mean they are protected from the risk of unemployment and well placed for a prosperous retirement (two assets that seem more aluable today than they did before the crash), so they are more capable of taking the hit than most ordinary families outside the public sector. Upping the retirement age would also be a boon to the structural deficit, especially if it was aplied to people currently nearer to retirement than governments are currently considering.

Ours is not a costed plan, but the underlyig principle is clear – governments should focus on filling the fiscal hole with taxes that do least to distrort incentives and expenditure cuts focused on transfer payments rather than investment (which includes investments in making public services more efficient in the future). That means all of us taking some pain now, and a proper safety net in place to protect the most vulnerable. The inevitable legacy of this crisis is that many of us will have to work harder for less money, at least for the next few years. Trying to soften the blow by cutting investment in our future productive capacity may be politically expedient in the short term but a decision we would repent at leisure. On this, no doubt, Krugman and Sachs, and maybe some less liberal economists too, would surely agree.

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