Spendthrift Sam and Judicious Janet

Recently, I bemoaned the bipartisan agreement that the government needs to "tighten its belt." This conventional wisdom is just plain wrong. I pointed to a column by economist Paul Krugman to explain why.

Apparently, some readers had trouble understanding how inflation and debt can sometimes work to our advantage (and by some readers I mean one in particular). Admittedly, it's counter-intuitive. If government debt contributed to our economic stagnation, how can more government debt get us going again?

After the jump, my attempt at paraphrasing Krugman's argument.

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First, a recap. Krugman asks us to imagine a world in which there are only two kinds of people: Spendthrift Sams and Judicious Janets. Sam is in debt and Janet is a saver. But because of, say, a collapse of a housing bubble, Sam has to quit borrowing, quit spending, and start paying down his debt.

Sound familiar? Krugman explains how the usual solution to this is for interest rates to fall, thus encouraging Janet to begin spending instead of saving, thus making up for the drop in spending by Sam. But the usual solution doesn't work when interest rates are already so close to zero that they can't fall any more. Some other tool is needed.

Krugman explains how inflation can be a tool to get the economy going again when interest rates are up against this "zero lower bound." Inflation erodes both assets and debt, but, as Krugman explains, "the Sams are balance-sheet constrained, while the Janets aren’t, so this is a net positive for aggregate demand."

What's in it for Judicious Janet, whose assets are eroded? It allows her assets to be productive. If Janet has her assets invested in, say, a factory, that factory is currently idle, or at least under utilized, because Spendthrift Sam is deep in debt and unable to purchase the output of Janet's factory. Anything that helps Sam erode his debt and begin spending again hastens the day when Janet's factory can resume full production and start making more money for Janet.

If you have moral objections to using inflation to hasten this process, Krugman offers a different tool. The government can borrow money and use it to help Sam find a job. With a paycheck again, Sam can pay off his debt and start buying output from Janet's factory again. The economy grows -- not by inflation but by an increase in total economic activity. There's no need for the government to "overspend indefinitely," as our reader puts it. As the economy grows, the need for government borrowing lessens, and the debt to GDP ratio stabilizes and even shrinks.

If, on the other hand, the government "tightens its belt," Sam stays jobless longer, others join him on the unemployment line, their collective debt remains a drag on the economy, and the cycle gets worse. Janet's factory remains idle, so she loses, too.

By the way, if you wonder what makes the most recent recession different from the previous three, well, besides being deeper, it was also the only one where government employment dropped. In the previous three recessions, government employment rose, helping pull the country out of recession. Not this time.

Source: Ezra Klein.

Note that the one spike in government employment during the recent recession was temporary hiring for the census. That didn't last long and even at its peak, government employment still didn't help to pull us out of recession as it did during the recession of 2001. By laying off teachers, policemen and firemen, we're shooting ourselves in our foot, folks.

As Krugman says, "The bottom line, then, is that the plausible-sounding argument that debt can’t cure debt is just wrong. On the contrary, it can -- and the alternative is a prolonged period of economic weakness that actually makes the debt problem harder to resolve."