Budget Craziness...

OK, Mr. President, I think that proposing budget cuts in advance of the Republican onslaught, given the sheer craziness of our media and given the unfortunate state of public opinion, was likely shrewd and necessary political posturing. However, you should be aware of how wrong it is on the merits.

First, let's consider the factors which generally go into determining what the marginal cost of public funds are. Because taxing the populace engenders disutility and discourages work (although not as much as you might think), raising $1 of revenue "costs" society more like $1.05 to $1.10. (This needn't be the case, if policymakers got serious about shifting taxes to gasoline and carbon rather than work or savings, this could be substantially reduced.) Secondly, spending, at the margin, is borrowed. This usually means that the actual cost is even higher. Yet, now the government floats 5-year Treasuries at 2% interest -- an historically low borrowing rate. Meanwhile the Fed predicts nominal GDP growth at 5% over the next few years. Hence, any money the government borrows now will simply be easier to pay back down the road, as a percentage of GDP. This should lead us to discount the marginal cost of government spending at present.

Lastly, and most importantly, are the Macro implications of spending. An additional dollar of government spending is expansionary, and therefore increases inflationary pressure. This raises interest rates, and it also is likely to engender a reaction from the Federal Reserve, who would respond by raising interest rates/keeping rates higher than they otherwise would, in order to keep inflation under control. Hence, there is no effect on overall output, although government spending "crowds out" private investment. In normal times, this is another factor for why we should want the government to be as small as possible. However, now short-term treasuries, the Fed's usual mechanism for controlling interest rates, is stuck at the zero lower bound. Given that core inflation is now at 1.0% for the past 12 months, and expected to be roughly 1.3% for 2011, and given that unemployment is at 9.0%, the Fed would "normally" respond by cutting interest the interest rates, which in this case are unfortunately pegged at zero. The current Fed has been very slow to change course or respond to events, and have largely taken a very passive, wait-and-see attitude to the current economic malaise. During the "we're all gonna die" phase in the wake of the Lehmann collapse, the Fed pumped $1.5 trillion into the economy. Over the following two years, on net, the Fed has done roughly nothing, while inflation has, predictably, stayed at bay and unemployment, predictably, has stayed high. Hence, every additional dollar the government spends now is not likely to be offset by the Federal Reserve -- at least not completely. Not only that, the money that the government spends will increase employment, and will be spent in turn. The CEA formerly used a fiscal multiplier of 1.5, but in a depressed economy, this is likely to be quite conservative. A multiplier of 2 is likely to be more realistic.

Hence, in normal times, $1 of government spending might "cost" $1.20 or so, now we should discount this marginal cost by two factors. The first by the degree to which repaying debt becomes easier in the future, and the second to which that spending increases the size of the economy. Hence, MB - MC = $2 - $1.20*(.97^5) => spend money now! This implies that the marginal cost of public funds, at present, is at an historic low and certainly less than the marginal benefit of government spending, even when we assume that said government spending has no inherent intrinsic benefit, and so cutting spending now makes less sense than at any time in US history since 1937.

But no one in the media apparently understands this, and so it is too much to ask that you stand up for more spending. But what you should keep in mind is that, if you agree to a budget cut of some sort, that it will hurt the economy -- aside from the bad created by cutting government programs and freezing the salaries of federal workers, who are already underpaid and who will stand to lose more talent to Wall Street as a result. And since there will be negative consequences for the economy, it is absolutely imperative that you attach two sensible Fed appointments to whatever compromise you reach.

If not, and despite a rash of good economic news in recent months, our Japan-style economic malaise could well continue for another few years, just as China continues to get rich...