Why Sequester May Be Exactly the Right Policy for the Economy

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What if the sequester that everyone thought we must desperately avoid turns out to be exactly the right policy?

One useful intellectual exercise is to assume that our political system is smarter than individual politicians or parties. Call it the wisdom of crowds, or the Efficient Government Hypothesis. The idea is that the outcomes our system produces are better than the positions of those who seek to influence the outcomes.

So the combination of the sequester and the start of the year Obama tax hikes is telling us something that almost no one in politics today argues: We can afford short-term deficit cuts produced by spending cuts and tax hikes, and we can safely ignore the long-term deficit.

Now keep in mind that this is exactly the opposite of what appears to be the consensus. Federal Reserve Chairman Ben Bernanke is probably the most prominent proponents of the view that the U.S. needs to adopt a Augustinian approach to deficits: Lord save us but not now. The basic idea is that the economy is so weak that the government needs to run short-term deficits, but the long-term deficit is so scary that it needs to be addressed as soon as possible.

The primary dissent from this view comes from Republicans who argue that the U.S. government has a spending problem and a deficit problem. They say that both long-term deficits and short-term deficits need to be addressed right now.

Which means that the actual policy we've adopted — short-term deficit cuts while ignoring long-term deficits — has nearly zero supporters (the notable exception being CNBC's Larry Kudlow). Any decent contrarian should at least ask: Could we have stumbled upon the right approach?

The Sequester Model

The key to this kind of exercise is intellectual humility. Instead of trying to figure out whether the outcome fits with your models about how the economy works, you need to ask what it would take for this to justify this outcome. That's a hard thing for people deeply interested in economics to do because we tend to be deeply wedded to models that we think best explain things.

So what is the Sequester Model? In the first place, it seems to assume that short-term fiscal stimulus is ineffective or counter-productive. This isn't all that radical. Until a few years ago, this was the widespread conclusion of most economists. A lot of folks have moved away from this view — despite the seeming ineffectiveness of stimulus under the Obama administration (Paul Krugman and others have argued that the seeming ineffectiveness was due to inadequate stimulus, for example).

How could short-term spending cuts and tax hikes help in a sluggish economy? The most obvious answer is that they could encourage central bankers to persist in policies aimed at providing monetary stimulus. If monetary policy is more effective than fiscal policy right now — perhaps because we are not, or are no longer, in a "liquidity trap" where monetary policy is ineffective — this is the better policy.

There's also a deeper, if more controversial, reasoning going on here. Monetary easing encourages the growth of aggregate demand through processes closer to free markets than fiscal policy driven by government spending. Sure, Austrian economists will tell you that people closer to the easing — banks — get an unfair boost. But the effect on the broader economy from monetary stimulus may be less distortive than fiscal stimulus. If the government is given to wasting money on things such as schools to nowhere and bombs that get dropped on foreign infrastructure, monetary policy might be better because actual individual economic actors decide the direction of the added spending.

The higher taxes may be harder to justify, at least on a short-term economic basis. But this isn't impossible. Higher taxes on the wealthy may discourage government spending because it makes spending seem more expensive. What's more, higher taxes on the wealthy at least somewhat diminishes inequality, which also discourages government transfer payments. These, in turn, encourage monetary policy easing and increases in productivity to replace transferred wealth.

In the Long Run, We're All Old

So what about the long-term deficits? How could ignoring long-term deficits be a wise policy? Nearly everyone in politics today thinks that long-term deficits are a huge problem and need to be addressed through entitlement reform, which mostly means cuts to Social Security and Medicare. There are dire warnings that the U.S. will become the next Greece if we don't get our deficits under control. Could this conventional wisdom really be wrong?

Of course it could. The market for U.S. Treasurys certainly suggests that it is. Long-term Treasury bonds have no trouble attracting investors. There is no indication that the market sees a risk of default or of funding difficulties. The prices of inflation-protected Treasury bonds suggest no signs of looming inflation, despite mounting evidence that entitlement reform is not really a political possibility. Far from demonstrating that we need to get our fiscal house in order, the market seems to be saying the fiscal house is in order.

But what about the fact that entitlement spending is going to explode when all those baby boomers retire? Doesn't this mean that we have a long-term deficit problem that the Sequester Model is ignoring?

Nope. The main challenge we face on entitlements is not financial — it's demographic. It's not really even a question of "entitlements" at all. The challenge is just whether the economy in the future will be productive enough to produce all the medical care, food, and shelter required by the elderly when there are fewer people actually working. How we pay for this is secondary matter.

To put it differently, no matter what budget reforms we enact, we have a long-term care problem — not a long-term deficit problem. Even if we dramatically cut down on the long-term deficit by slashing entitlement spending, so that any care in excess of that has to be funded privately, we'll still face the same challenge.

That challenge cannot really be solved through budgets. No matter how much we tax now, no matter how much we save now, in the future the economy will be limited to what it is able to produce. The challenge is to set that limit as high as possible, so there is as much as possible for the young and the old to divide it among themselves according to market processes.

The point is that we're going to work, one way or another, to keep an elderly population in decent conditions. Whether we do this by making sure Social Security is self-funding through benefit cuts or tax hikes, or by creating structures that encourage people to have more children who can care for them, or by some other means, is secondary at best.

And this is where the Sequester Model may be wiser than politicians. Many politicians seem to suppose that if we cut benefits we'll somehow reduce the drain on real resources in the future from an elderly population. This just isn't true. Perhaps by keeping the drain on resources front and center, leaving the long-term deficit high keeps us aware of the economic challenge of an aging population.

So is the Sequester Model right? It's probably too early to tell. But one thing that is sure is that the Sequester Model is not necessarily wrong just because it lacks supporters in today's political scene.

By John Carney; Follow him on Twitter @Carney