Mike Konczal points out Gene Sperling’s recent performance on MSNBC, arguing that uncertainty about long-term deficits is weighing on the economy.

What surprised me is that I was just (re-)reading about the early days of the Clinton economic team, and back then Sperling was on the other side of the debate. In Robert Rubin’s account of the famous January 7, 1993 meeting (well, famous if you’re into economic policy debates from two decades ago), the deficit hawks were Al Gore, Lloyd Bentsen, Leon Panetta, and Rubin. The people who wanted more stimulus and less deficit reduction were Robert Reich, Laura Tyson, George Stephanopoulos, and Sperling. (See In an Uncertain World, pp. 123-24.) In Clinton’s memoir, Sperling was also on the side of stimulus and investment: “Gene Sperling made a presentation of options for new investments, arguing for the  most expensive one, about $90 billion, which would meet all my campaign commitments immediately.” (My Life, p. 461.)

Of course, the economic conditions were different back then. Interest rates actually were high (ten-year Treasuries were at 7 percent, with inflation under 3 percent), and Tyson, Alan Blinder, and Larry Summers were all arguing that deficit reduction would lower interest rates and stimulate growth. Alan Greenspan was also implying that if the new administration reduced the deficit, he would help lower interest rates. In other words, back then there probably was something to the idea that deficit-cutting could stimulate the economy.

That’s clearly not true today, because interest rates are already about as low as they can be. Or at least, if you’re going to argue that deficit-cutting will stimulate the economy, you have to come up with some other transmission mechanism, because it can’t be interest rates. There are valid reasons to want to fix our long-term debt problem, but stimulating the economy in the short term isn’t one of them.

So why is Sperling now the man arguing for deficit reduction? The simplest explanation is that he’s on TV defending his boss, and his boss wants deficit reduction. The other explanation, which Konczal suggests, is that Sperling and the rest of the economic team are products of the Clinton administration, and deficit reduction is what worked for them.

Summers, who was a deficit hawk in 1993, is now in favor of near-term traditional fiscal stimulus – an extension of the payroll tax cut and more infrastructure spending — and deficit reduction in the medium term. He can see the difference between 1993 and today. Of course, having left the administration, he also has the liberty of speaking his mind.

In some cultures asking how the kids are doing is a colloquial way of asking how the individual is faring, acknowledging that the vitality of the younger generation is a good metric for the well-being of society as a whole. In the United States, the state of the kids should be an important indicator. Young workers bear the significant burden of funding intergenerational transfer programs and maintaining the structure of payments that flow in the economy. Today, the kids’ outlook is almost as bleak as the housing market; they are unemployed, underwater on student debt, and out of luck from a reluctant political system.

Currently, even after a slight boost in jobs growth, unemployment for 18-24 year olds [correction: should be 18-19 year olds] stands at 24.7%. For 20-24 year olds, it hovers at 15.2%. These conservative estimates, using the Bureau of Labor Statistics U3 measure, do not reflect the number of marginally attached or discouraged young workers feeling the lag from a nearly moribund job market.

The U3 measure also does not count underemployment, yet with only 50% of B.A. holders able to find jobs requiring such a degree, underemployment rates are a telling index of the squeezing of the 18-30 year old Millennial generation. While it appears everyone is hurting since the financial collapse, young adults bear a disproportionate burden, constituting just 13.5% of the workforce while accounting for 26.4% of those unemployed. Even with good credentials, it is difficult for young people to find work and keep themselves afloat.

If companies are unwilling to hire bright young college graduates even at a relatively low salary and minimal benefits, will they ever be willing to hire anybody at all?

Jobs aren’t the whole story. Recent college graduates, those in the labor force with the freshest batch of knowledge and skills, are currently underwater and sinking fast with unprecedented student loan and personal debt. Average student debt for the class of 2008 was $23,200, an increase over four years of about 25%, meaning that students are knee deep in negative equity between their educational investment and actual earnings.

Between inflated student debt and the lack of available jobs for qualified graduates, students are defaulting at an all time high level of 7.2%. From 2008 to 2009, student debt defaults jumped about 30% to $50.8 billion. This earning-to-debt gap not only hurts lending institutions, but also may affect students’ future abilities to borrow – a significant hurdle in our credit driven economy.

If student debt and job stagnation continue, younger workers will face real structural unemployment (as opposed to the fake kind that had been suspected by some economists, but was recently debunked by the San Francisco Fed).  The more time these young workers spend unemployed and underemployed, the greater chance for future structural unemployment due to deteriorating human capital.

High debt, high defaults, and low family earnings will prevent many students from finishing college at all. High unemployment for those who do manage to graduate with a degree will create barriers for those unable to start their careers. As economists have shown, most current deficits can actually be attributed to the decrease in tax revenues ­­- a debilitating trend that will continue without well-targeted action.

In order to combat such structural problems, the need for investment in education and jobs is clear. This investment will act as an insurance policy against persisting future structural unemployment and subsequent government revenue declines. This investment can take the form of direct funding for public higher education, increased financial aid to students, and expanded federally guaranteed loan and grant programs. As many states have slashed and burned public higher education budgets, as in Massachusetts, federal attention should be directed towards this crisis. The 2009 stimulus funding provided only two years’ worth of support to sustain public higher education in the Commonwealth, where universities have historically been a top priority. The need for a long-term restructured investment plan in public higher education is obvious, not just in Massachusetts, but the other forty-nine states as well.

At the same time, insurance against the impending doom of climate change could be taken out in the form of a green jobs bill, providing work and an outlet for innovation for recent college graduates. As Robert Pollin and Dean Baker have suggested, long-term investments in rebuilding a green energy industrial base, complete with manufacturing and R&D, could revitalize the entire economy if funded as part of a 10-year plan to the tune of $50-100 billion. Such investment could create 660,000-1.3 million jobs per year – the kind of growth that seems to have escaped our collective memory.

Green collar industry would naturally target the young workers who are up to date on the high-tech nature of green jobs, and much research and development would, as with most budding industries, take place at academic research institutions like public universities – a two-for-one stimulus in both jobs and education.

In order to solve future structural problems in the United States and ensure a future for the sandwich generation, fiscal policy focused on educational and job growth is crucial. While deficit hawks may squawk about the costs, the burden of repayment is on younger people Without adequate education and careers for students, we will never be able to balance the budget. In the long run, it makes more fiscal sense to create jobs and collect tax revenue than to rely on a model that merely waits for the private sector to invest.

While the political feasibility of such a measure is questionable, the incentives are there no matter on what side of the aisle you may sit. Jobs investment will improve employment. Education will increase productivity (and profits too), increasing tax revenues from businesses and personal incomes and helping balance the budget. Crisis is not the time for austerity, and these types of investments in the viability of the U.S. economy should be done when money is at its cheapest.

In a dire job market, facing imminent climate change, and lagging aggregate demand, keeping the younger generation afloat will inevitably be a decision to sink, swim, or at least throw out some life jackets.

This could be a midsize political battle in the run0up to the midterm elections, as discussed by The New York Times. The positions on both sides are too obvious to warrant repeating. If I recall correctly, the Obama administration hurt itself by underestimating the course of future unemployment a year ago when it passed the stimulus (most people were making the same mistake at the time), so now if you compare actual unemployment against original projections it looks like the stimulus had no impact. But that was a forecasting error and has nothing in itself to do with the stimulus itself.

Menzie Chinn has an overview post on the debate in which he argues that, at least from the standpoint of economists, it’s hardly a debate: the stimulus worked.

He points out that leading private-sector economic consulting firms are crediting the stimulus with significant impacts on GDP growth and employment. Here’s the money chart (originally from the Times):

Chinn discusses the types of models used to generate those forecasts, and competing models used by a few academics that yielded different results. He also points out that the CBO also estimates significant growth and employment impacts. If you want to pursue the matter further, he links to a couple of contrary arguments.

Of course, none of this will matter in the end because, as someone (Barney Frank?) said, you can’t get elected saying things would have been even worse without you. Unemployment will still be high in November and the Republicans will blame it on Obama. Voters aren’t going to believe macroeconomic models, don’t realize that unemployment is a lagging indicator, and will (with a little justification) think that Obama could have done more to create jobs.

My opinion is that both are valid purposes. There probably is a limit to the number of tens of billions of dollars the government can spend next month without wasting some of it. But given the projected duration of the output gap (the difference between potential and actual GDP, meaning that the economy is performing below its full-employment capacity), I think there is also value in programs that take several quarters to disburse their money – as long as those programs are also good investments.

One major area of spending is education, where the plan includes more than $150 billion in new spending over two years. While politicians (and economists) reflexively cite education as an area where investments can have positive long-term returns (through increases in productivity which increase GDP and our average standard of living), I wanted to see what empirical research there has been on this topic. There has been a lot of research on the impact on individuals’ earnings of additional education (this is a common example used in first-year statistics classes), but somewhat less on the impact on national economic growth.

Two leading researchers in the economics of education are Claudia Goldin and Lawrence Katz. I looked through their papers, and the simplest one I found that covers this topic directly is “The Legacy of U.S. Educational Leadership: Notes on Distribution and Economic Growth in the Twentieth Century.” This paper discusses the United States’ educational lead over other countries in the 20th century and the impact it had on the U.S. economic growth. The main difference between the U.S. and Europe was not elite education, but the development of mass secondary education between World Wars I and II: as the economy became more technologically sophisticated, there was greater need for an educated workforce, including in production jobs.

Many studies have found that countries with more educated labor forces experience higher rates of economic growth. More difficult to determine is the extent to which the positive relationship between education and growth results from the causal impact of education on
growth and not from reverse causation or from confounding factors correlated with both education and growth. Educational advance can contribute directly to economic growth by increasing the human capital and thus the productivity of the work force, and indirectly by increasing the rate of innovation and adoption of new technologies.

They addressed only the first effect: the impact of higher productivity. The results:

The direct impact on economic growth of the expanding education of the work force was about 0.37 percent per year . . . since 1915, and the educational factor accounts for 23 percent of the 1.62 percent per year increase in U.S. labor productivity (non-farm, non-housing business GDP per worker for 1913 to 1996 . . .).

In other words, 23% of productivity growth in the last century was due to increased education. In other studies, they discuss the decline in the rate of educational growth (the average educational level of the workforce) that has set in since 1980. If increased spending on education can reverse that decline (a big if, I know), then it could have a significant impact on productivity for decades to come.

I know this is a very controversial topic. For an opposing viewpoint, Arnold Kling says (referring to Goldin and Kaz’s new book) that what’s really at work there is that the average educational level can’t keep growing at its earlier pace, since the current level is higher than the former level, and it just isn’t possible to dramatically increase college attendance and graduation rates.”

If readers know of other more recent, or contradictory, studies on the relationship between education and economic growth, please share.

I was initially surprised by Obama’s forthrightness on the deficit question, but on reflection there are three good reasons for him to do it:

1. He wants to lower expectations by making the case that we have a serious deficit problem before taking office.
2. He wants to signal that he is aware of the deficit issue, to try to defuse the attacks he is going to get from fiscal conservatives regarding his stimulus plan.
3. He wants to use the current crisis – and the political opportunity it gives him, as a new and generally popular president with significant majorities in both houses – to tackle the long-term retirement savings problem.

If you parse the sentence, in saying “even after our economy pulls out of our slide,” Obama is saying that the long-term deficit problem would exist with or without the current crisis – and he is right. A $1.2 trillion deficit, caused by a steep fall in tax revenues, partially by the costs of various bailouts, and a little bit by two ongoing wars, is small compared to the Social Security and Medicare funding gaps ahead. In signaling that he will announce some kind of approach to entitlement spending by next month, Obama is implying that he wants to take on not just the short-term recession, but also the long-term deficit problem.

This is good for two reasons. First, someone has to face the problem. President Bush “tried” (not very hard) to do something about Social Security in 2005, although the general direction of his proposal, in shifting from a defined-benefit to a defined-contribution model, would have shifted risk from the government onto individuals.

Second, there are economic reasons why long-term sustainability should be addressed at the same time as short-term stimulus. Virtually everyone (even Martin Feldstein) favors a large, debt-financed government stimulus package. However, the more the government borrows, the more risk there is that lenders will worry about our ability to pay off the debt. While few people expect the U.S. to default, the more widespread fear is that we will print money (in a more sophisticated form, of course) to inflate away the debt. Because of those fears, large amounts of borrowing will drive up interest rates, especially as the economy recovers, both for the government (increasing our interest payments) and for the economy as a whole (undermining growth). The solution, if there is one, is to put forward a credible plan for dealing with the long-term retirement problem.

The risk, of course, is that Social Security and Medicare can be politically lethal, which is one reason President Bush backed off so fast. But I still think this is the right bet for Obama to make. Insofar as any solution is going to involve some pain (lower benefits, increased benefit age, higher taxes, increased control over health care), it is going to be easier to pass in a time of perceived collective crisis. And being willing to tackle the problem could also help gain support from fiscal conservatives for the stimulus that we need now.

The optimal fiscal package should be timely, large, lasting, diversified, contingent, collective, and sustainable: timely, because the need for action is immediate; large, because the current and expected decrease in private demand is exceptionally large; lasting because the downturn will last for some time; diversified because of the unusual degree of uncertainty associated with any single measure; contingent, because the need to reduce the perceived probability of another “Great Depression” requires a commitment to do more, if needed; collective, since each country that has fiscal space should contribute; and sustainable, so as not to lead to a debt explosion and adverse reactions of financial markets.

When it comes to global economic policy, the IMF is as close to the Establishment as exists. The Federal Reserve may be more powerful, but it lacks the IMF’s explicit mandate to oversee the global economy and step in when needed; the MITvard economics department in Cambridge, Massachusetts may have more intellectual prestige, but its members do not have hundreds of billions of dollars to throw around. As a result, the IMF is less likely to come up with radical new ideas than to show where the global consensus is moving.

Seen in this light, the IMF report confirms the general movement toward large stimulus packages composed largely of public spending that has gathered momentum in the capitals of several wealthy nations, and the U.S. in particular. The IMF recommends government spending over tax cuts, on the grounds that households and firms may choose not to exercise any additional purchasing power they get from tax cuts, and also because the time lags necessary to spend lots of money are compensated for by the expected length of the downturn. When it comes to boosting purchasing power, governments should target “those consumers who are most likely to be credit constrained” – the unemployed, the poor, and homeowners facing foreclosure.

There is one potentially controversial area that the IMF touches on: government support for “flagship” domestic industries (such as the auto industry in the U.S. and France). The authors warn against this type of policy because of its “inherent arbitrariness, and risk of political capture,” and perhaps most importantly because “direct subsidies to domestic sectors lead to an uneven playing field with respect to foreign corporations, and could lead to retaliation and possibly trade wars” – the risk Simon discussed in connection with the French bailout.

The report also raises perhaps the toughest issue in all of this, which is the issue of “fiscal sustainability:” “it is also essential that fiscal stimulus not be seen by markets as seriously calling into question medium-term fiscal sustainability.” Put another way, governments have to spend lots of money to stimulate their way out of this recession, but if they spend too much no one will lend them money anymore. This, of course, assumes that there is such an optimal point, where it is possible for a government to spend enough to get its economy going, but without reaching the point where no one believes it can pay the money back. Striking this balance will be harder for some countries than others, and there is no assurance that it will even be possible for some countries. The U.S. is better off than most, because we have the luxury of the world’s reserve currency, but even so there may be a point at which investors will back away from the dollar.

In short, this is the major risk of fiscal policy, and no one has a perfect answer to it. Right now I think a majority of economists (though not all) are of the opinion that the downturn is so severe that governments should err on the side of too much stimulus and worry about things like inflation, balanced budgets, and interest rates later. From one perspective, they are probably right, because long-term fiscal sustainability depends on economic growth more than anything else. The last time people were painting nightmare scenarios about the U.S. government debt was during the deficits of the 1980s – and a couple of tax hikes (under Bush Senior and Clinton) and a long economic boom took care of that. In putting the emphasis on spending, not on fiscal prudence, the IMF is also largely endorsing the stimulus package that will soon be forthcoming from the Obama administration.

The cynical will also note that these recommendations are more or less the opposite of the fiscal austerity measures imposed by the IMF during the emerging markets crisis of 1997-98. I don’t think that’s a completely fair criticism, however, because the problems are different – capital flight and government solvency, as opposed to a collapse in demand. But in any case, maybe the IMF learned something.

More than 22% of the unemployed have been out of work more than six months, which is usually when unemployment benefits expire. For this and other reasons, only 32% of the unemployed were receiving state benefits in October. These are more reasons to expand unemployment benefits in multiple directions, at the very least for a limited time period. Alan Krueger has described the other ways our unemployment insurance system is broken.

Unfortunately, there is fear that President Bush (remember him?) will veto the stimulus package, including extended unemployment benefits, that the Democrats want to pass in November, thereby accomplishing nothing except delaying it by two months. Sigh.

So, it looks like we’re in a recession. What’s a recession?

A recession is a period when overall economic activity contracts. In most times, overall economic activity increases, for two reasons. First, each year there are more people in the workforce, because the population of the US, like most but not all countries, is increasing. Second, most years, the average person is able to produce a bit more than in past years because of improvements in technology, processes, and so on. For a recession to occur, per-capita economic activity has to decline more than enough to compensate for population growth.

How is economic activity measured? The most common (and official) measure is gross domestic product (GDP), which is the aggregate value of all the goods and services produced or provided in the country. GDP is calculated by adding up private consumption (all the stuff that ordinary people buy), capital investment (factories, houses, etc.), government spending, and net exports (exports minus imports).

Why does GDP matter? Because GDP measures all the stuff that we produce, it also, roughly speaking, measures all the stuff that we can have as consumers. I say “roughly speaking” because, in the short term, we can consume more than we produce, by importing more than we export. But in the long term, while it may be possible to maintain a reasonable trade deficit indefinitely, it’s tougher to finance increases in consumption – what we need to have a higher standard of living – through ever-increasing imports. So if we want our children to lead better (material) lives than we do, we need GDP to increase.

Why do recessions happen? There are many, many reasons, but every recession is overdetermined – you can point to multiple explanations of why it happened, so you can never isolate one specific cause. One important thing, however, is that however they start, recessions are self-reinforcing. As consumers spend less, businesses sell less, so they need to reduce costs, so they lay people off or reduce hours, so consumers have less money, so they spend less, etc. As business profits decline, stock prices fall, so people feel less wealthy, so they spend less, etc. As people have less money, housing prices fall, so people can get less money from their home equity lines of credit, so they spend less, etc. As people make less money, state and local tax revenues fall, so those governments have less money to spend, reducing government spending, etc. And so on.

There is another self-reinforcing factor at work that may be particularly pronounced this time around. The more people hear about a recession (or a global economic crisis), the more worried they get, the less they spend, etc. And this is one reason why many economists are worried about this quarter (October-December). We arguably have never before seen the concentration of bad news, amplified by the always-on nature of the contemporary news media, that we saw between the Lehman bankruptcy on September 15 and the bank recapitalization announcement of October 15. Very little of that impact showed up in the Q3 (July-September) personal consumption figures, which were already bad; given how jittery many people are about spending (on which I’ve already expressed my opinion), this quarter could be much, much worse.

What can you do about a recession? As you might guess, there is a wide variance of opinion on this question. However, the following three options cover most of the spectrum:

1. Stimulate demand. If consumers and businesses won’t spend enough, the goal is to get them to spend more, or to otherwise compensate for their lack of spending. This can be done via tax rebates, increased welfare benefits, or other measures that put more money in people’s pockets, or through increased government spending. In either case, the goal is to break the self-reinforcing cycles described above.
2. Stimulate supply (aka “supply-side economics”). The goal is to increase incentives to produce stuff by reducing tax rates on things like income and capital gains. This is different from stimulating demand because the focus is not on putting money in people’s pockets so they will spend it, but on giving people the incentive to produce more.
3. Reduce interest rates. In general, reducing interest rates makes it easier for people and businesses to get credit, which increases their purchasing power and therefore their spending and investment.

One problem we have today is that there is little additional benefit to get by reducing interest rates. First, interest rates that the government has control over are already extremely low (the federal funds rate is currently 1.0%). Second, the availability of credit seems to be constrained more by banks’ low capital ratios and fear of risk than by the price of money.

That leaves government action to stimulate demand or stimulate supply. I separately discussed the stimulus plans of Barack Obama and John McCain. Roughly speaking, Obama favors stimulating demand; McCain, stimulating supply.

Whether we get a large economic stimulus package in the US – the economy whose health affects, for better or worse, just about everyone in the world – could very well depend on who is elected on Tuesday. For a summary of their short-term economic proposals, see here.

If Barack Obama is elected, we are likely to see a large stimulus package. It would probably include the measures that many economists are favoring, including extended unemployment benefits (and suspension of tax on those benefits), immediate cash aid to state governments, increased home heating cost aid, and infrastructure spending. These measures will have a direct impact on the economy by increasing spending now, while increasing it in ways that are necessary (keeping poor people alive) or that are productive long-term investments (infrastructure). Some of his other suggestions will have a more limited impact on the economy, such as a cash tax rebate, or are more or less irrelevant to the economy, such as relaxing the minimum distribution requirements for retirees.

With John McCain, we are not likely to see a stimulus package – or, more accurately, the package we see will be built around tax cuts that are not likely to have a direct economic impact. His proposals include: reducing taxes on retirement account withdrawals; increasing capital loss write-offs; reducing long-term capital gains tax rates; exempting unemployment benefits from taxes; also relaxing minimum distribution requirements; extending all of the Bush tax cuts; and reducing corporate tax rates. Except for the tax cut on unemployment benefits, these proposals suffer from the basic problem that undermined the last stimulus package this spring: in tough economic times, people take their tax rebates (or tax cuts, or cash you give them in any form) and stuff it under their mattresses, or pay down debt. McCain’s plan also includes the famous (or infamous) proposal for the government to buy up and refinance mortgages directly. (Obama favors increased loan modifications and legislation to eliminate some of the legal barriers to modifications.) But while that could potentially help homeowners and lenders, it doesn’t increase economic activity any.

(For an explanation of why different programs have different marginal impacts on GDP, see Menzie Chinn’s post.)

That said, given the way legislation is passed in Washington, the final package is likely to differ from either person’s proposals, whoever is elected. But the next major step that our government takes to combat the financial and economic crisis will depend directly on the outcome of Tuesday’s election.

Previous attempts to use government spending to stimulate an economic recovery, particularly spending on infrastructure, have not been successful because of long legislative lags that delayed the spending until a recovery was well underway. But while past recessions lasted an average of only about 12 months, this downturn is likely to last much longer, providing the scope for successful countercyclical spending.

This is basically what we said in the National Journal and what Simon said in this morning’s testimony. I’m not claiming that Feldstein listens to what we say (I strongly doubt it). But his op-ed emphasizes the fact that most economists from across the political spectrum are on the same page on this issue.

Update: “Business executives and Republicans” are on board, too.

1. The global economy is slowing fast, and likely faces an unprecedented (since 1945) recesssion.  The pressures on emerging markets are intense, and inflexibility in Europe in both policy (Eurozone, I’m talking about you) and labor markets (for almost all the European Union) creates serious macroeconomic vulnerability at this stage.

2. In the US, significant (OK, also unprecedented) countercyclical policies have now been put in place.  In particular, the Fed is running through its anti-deflation playbook (which Mr Bernanke was kind enough to publish back in 2002).  We have no idea how to properly measure the scale, let alone the impact, of this increase in: liquidity, contingent liabilities, actual or potential direct lending to almost everyone in the US, and, via unlimited swap lines to some central banks and new $30 billion swap lines to four emerging markets, to many institutions around the world.

3. So deciding what to do with fiscal policy is very hard.  In other industrialized countries, you can rely on “automatic stabilizers” to a greater degree than in the U.S., meaning that their government spending (and deficit) increases in recession because unemployment benefits and the like are more generous.  In the U.S., we have to make a conscious decision.  And that decision needs to be made soon, within a month or so, because any fiscal stimulus works only with a time lag – and the more you want to do things that definitely raised GDP (like infrastructure), the longer the time lag.

So my recommendation is… (well, read the testimony; the numbers are on the first page; detailed recommendations follow on how to spend, for both immediate impact and longer-term benefits).

Comments welcome – there is still a long way to go, in terms of legislation design and implementation.

Update: If you want to see the actual session courtesy of C-SPAN, go here. (Note there were 8 speakers and the session was two hours long.)

(Like Simon argued in the National Journal, but with more data.)

On the topic of regulation and economic stimulus, Mark Thoma cites and expands on Larry Summers, who argues that we need to not just give the economy a boost in the short term, but take advantage of the opportunity to take steps – both investments and regulation – to boost productivity in the long term.

Mark Thoma (again) and Yves Smith both provide roundups and analysis of the currency crisis, which Simon raised a couple of days ago. Quick summary: it could be bad.

So if you can’t sleep, there’s plenty to read and worry about. (Or you could watch the World Series.)

The first important thing to keep in mind is that the U.S. government, unlike every other government in the world, has the ability to borrow virtually unlimited amounts of money. The U.S. dollar is still the world’s reserve currency, and Treasury bonds are still the risk-free asset of the global economy. In times of crisis, when smaller countries find it harder to raise money, the U.S. actually finds it easier, because investors are ditching whatever risky assets they are holding and buying U.S. Treasury bills and bonds instead. Currently, the U.S. is paying virtually no interest on short-term borrowing (and probably negative interest in real terms).

The second thing is that, while 12-figure numbers are thrown around routinely, these large numbers do not all amount to pure losses. The $700 billion for the Paulson plan was initially intended to buy mortgage-backed securities which would eventually be resold, probably at a loss, but not necessarily a huge one. In the current form, $250 billion of that money is going to buy preferred shares in banks that (a) pay a 5% dividend and (b) will also be resold, in this case probably at face value (if the banks don’t buy them back after 3 years, the dividend goes up to 9%). On the other hand, guaranteeing the obligations of Fannie and Freddie, and new bank debt, also create additional potential exposure, but in each case it’s not as if the government has to borrow additional money now. In each case, the financial institutions being guaranteed have assets to match those liabilities, and the calculated expectation is that only a small proportion if any of these guarantees will ever be triggered.

So as others have put it, the government is in some ways acting as a bank. It is borrowing money by issuing more Treasury bonds to a market that wants lots and lots of Treasury bonds, and hence the cost of borrowing is not going up. Then it is using the money to buy financial assets from financial institutions. For the government, these assets may go up or down in value. For the financial institutions, they now have the cash that the private credit markets are unwilling to lend to them. In the current situation, this is an excellent use of the government’s unique borrowing power.

Still, the inevitable stimulus package will require yet more money, either in increased spending or reduced tax revenues. Some will no doubt protest that this is an unsupportable expansion of an already large and growing national debt. And it is true that the more money we borrow, the closer we come to the point where foreign investors and central banks may start looking for safe havens other than the U.S. dollar. But given that we are facing what could be the worst recession in thirty years – and given that the $100 billion stimulus implemented earlier this year wore off after one quarter – the government needs to err on the side of providing too much rather than too little stimulus. If there ever was a time for deficit spending (and I realize that there are people who think there is never such a time), this is it.

Besides, you don’t have to believe me; you can believe the latest Nobel Prize winner.

Update: The Economist points to two stories on the growing consensus that increasing the national debt is the way to go.