If Deficit Hawks Are Having a Broken Clock Moment, It’s Time to Tax the Wealthy

With inflation on the wane and the first round of interest rate cuts underway, the US is officially entering the next—and possibly most important—hypothesis test of the COVID recovery: Are higher interest rates here to stay? With the Fed cutting rates, you’re about to hear a lot more about neutral interest rates and r* (the long-term interest rate, the main tool the Fed uses to achieve its dual mandate for stable prices and maximum employment). Higher neutral rates are the unspoken assumption underlying the vast majority of post-COVID inflation punditry—and what Jay Powell kinda feels.

But 21st century macroeconomic policy has been undermined by a serial failure of policymakers to accept that neutral interest rates have fallen dramatically from the preceding century; instead, persistent near-zero interest rates have been the norm. This is not because the Fed wants lower rates, but because long-term economic trends have forced the Fed to keep rates lower. The consequence has been fiscal policy that overemphasizes budget deficits at the expense of full employment, costing Americans millions of jobs and trillions of dollars.

With broad consensus that deficit fearmongering led to a decade of economic underperformance, economists were highly supportive of aggressive COVID stimulus, resulting in the strongest and fastest economic recovery in a generation. Yet all it took was an ultimately transitory spike in inflation for deficit hawks to dominate economic debate again. Their dire predictions about what it would take to defeat inflation proved wrong, arguably because they were wrong about neutral interest rates again.

The challenge today is threefold: First, policymakers have to understand that there is genuine uncertainty about where neutral rates will land (an empirical question). Second, policymakers have to update their assumptions as data come in. If neutral rates don’t settle higher—a possibility backed by more evidence than public debates suggest—then pursuing the policy prescriptions of the last two years, especially around budget deficits, risks returning to the secular stagnation that has permanently stunted the US economy this century. Third, if deficit hawks are right, and neutral rates really have risen, policymakers must find ways to raise more tax revenue to reduce debt-service costs.

Conservatives’ plans—cut taxes for the wealthy and let others sort out the problems—pay no mind to deficits or interest rates. The question for the Left is whether hawks will again wield deficits to prevent movement on long-term progressive priorities. If neutral rates have not risen, giving in to that tomfoolery would be economic malpractice, again. However, if deficit hawks are finally right about interest rates, the question becomes whether they are willing to join forces with progressives to raise tax revenue from the wealthy so we can make the public investments we need to.

Two views of the REAL real interest rate

Among economic pundits, the most pervasive view of the post-COVID US economy is that it is fundamentally different from the pre-COVID economy, so interest rates will settle at permanently higher levels than we’ve seen in decades. We can all kiss 15 years of mortgage rates that start with numbers less than four goodbye, they posit. Though widely broadcast, this hypothesis is mostly based on vibes—and short-term movements in US government bond yields.

Like most real-time macroeconomics, thin explanation doesn’t mean a theory is wrong. If this is the case, those concerned about deficits have a point, and a strong one at that: At permanently higher interest rates, deficits and debt really do matter (though I am once again asking you to use interest payments as a share of GDP to avoid embarrassing yourself). With permanently higher debt-service costs, lowering debt levels can free up more fiscal space for investments in people and public goods.

If the higher interest rates vibes are correct, then higher debt levels really do call for significantly higher tax revenue—notice I did not say spending cuts—to stabilize these costs.

A second view is that the structural forces that drove low neutral interest rates haven’t gone anywhere, and that when the protracted Fed response to early 2020s inflation ends, low rates will return. This would point toward mechanically falling debt service costs over the next few years, making the white papers of the 2010s more appropriate policy resources than the yellowed volumes of the 1970s. Under low interest rates, the most macroeconomically beneficial policies capitalize on those rates to build state capacity and make public investments, while developing countercyclical policies to fight—or prevent—future recessions.

The roots of this debate are in the 1990s, when deficit hawks took over policymaking, and were vindicated by the results—at least until 2000.

Hawks in spring: the 1990s

For most Americans, the dream of the ’90s is in Portland, but for mainstream economists the dream of the ’90s was in Washington. After losing policy fights on inflation in the 1970s, when politicians opted for lapel buttons and price controls, and in the 1980s, when they went with a Reagan-style combination of huge (mostly regressive) tax cuts and large spending increases, deficit hawks finally won a policy argument.

And the 1990s economy was unambiguously better than the two-ish decades that came before. Armed with proof of concept, deficit hawks in academia, government, and the media loosely concluded the ’90’s had proved that eliminating deficits could lower inflation, cut interest rates, and induce an economic boom. This being 20th century macroeconomics, a theory and an experiment with N=1 was pretty compelling.

The aggregate statistics—inflation vanquished, record employment-to-population-ratios, real wage growth, lower interest rates, the faster productivity growth, and healthy GDP growth—seemed convincing (if we ignore the whole rise of Wall Street and cuts to critical public programs stuff). So too did the narrative: a simple story of virtue and success, with courageous policy wonks and politicians risking their careers with unpopular policies to close the budget deficit and creating the stronger and more stable real economic prosperity of the late 1990s for all Americans. Deficit hawks trumpeted their macroeconomic formula from the mountaintop, and had plenty of scribes happy to tell the tale. But reality complicated the story.

Deficit hawks get their wings clipped

Enter George W. Bush. Vice President Dick Cheney famously declared deficits didn’t matter, and the administration followed through. It passed two huge, regressive tax cuts, spending freely on wars and prescription drug benefits to line the pockets of Booz Allen and Big Pharma. But neutral interest rates somehow kept falling, and inflation and interest rates never took off; if anything, they stayed too low. This contradicted the deficit hawk narrative—the investment climate stayed favorable while government borrowing soared—but did little to diminish this view’s stature.

Unfortunately, interest rates were still arguably too low (roughly as high as last week) by the time the economy imploded in the late 2000s—and deficit hawks were very influential in the debate over the response, both in the size and duration of stimulus. Once again, the hawkish view of deficits missed, in ways entirely consistent with overestimating the neutral rate of interest. In the wake of the Great Recession, an inadequate fiscal response and a focus on long-term debt reduction led to a lost decade for the US economy in the 2010s—pushing hawks to the periphery when the next, even deeper, recession hit.

With the CARES Act and American Rescue Plan, policymakers went big, leading to a record-fast recovery. Large fiscal stimulus ran up budget deficits, but as with recent recessions, showed no signs of creating inflation—at least at first. Even after the economy reopened, it wasn’t until the fall of 2021 that inflation data showed broader price pressures.

Hawks of a feather flock together

After decades of low inflation, the sudden appearance of rapid price growth in a reopened economy dramatically changed vibes and sent out a bat signal to deficit hawks. Never mind that stimulus policy did exactly what was advertised: err on the side of stimulating the economy too much to ensure a rapid recovery and have the Fed cool the economy if inflation emerged. With Russia’s invasion of Ukraine further disrupting global supply chains and shifting the economic debate further, the hawks were everywhere—especially on TV—using a real economic conundrum as a weapon against successful policies that many had either turned against or never liked to begin with. Their critiques were and continue to be dubious, but importantly for this week’s rate cut, they were also based on the central assumption that high interest rates were here to stay. With higher rates and spending needs, lowering interest costs was crucial to all the things, and the only way to get there was closing deficits.

What if deficits are actually too high?

Concern about deficits isn’t always off base, and it’s irresponsible to assume it is now—we’ll know much more about this as interest rates settle over the next year. The bad news is that closing deficits costs money, and the revenue tweaks and spending cuts that many deficit hawks have argued for in the past no longer fit with current reality: a higher (and growing) share of mandatory spending given the coming of retirement age of baby boomers.

The good news is that cutting deficits by raising tax revenue is both better policy and better politics than many deficit hawks realize. Decades of regressive tax cuts have both boosted the fairness case for higher taxes on the wealthy and mean that even just raising taxes to levels from deficit hawks’ heyday would generate lots of tax revenue.

Further, economic research has shown the idea that taxing the wealthy comes at significant cost to economic growth works better in theory than in practice. Modern studies of regressive and progressive tax cuts have boosted the evidence case for taxing the wealthy as good policy. From a political point of view, cutting spending is not only unpopular, but extremely difficult. Mandatory spending now represents the vast majority of the federal budget, so the budget hawks’ serious case should center on raising revenue through more progressive taxation, and boosting the supply side of the US economy through public investment—not cutting spending in ways that inflict harm.

What if the hawks are wrong? Again?

First, if inflation and interest rates settle to levels within the range of recent history, we don’t need to cast out honest hawks into the wilderness—there is no reason to run up budget deficits just to keep taxes low for billionaires. The basic rules of managing debt payment costs still hold, but under the kind of demand-deficient regime the US has experienced since neutral rates went low, good macroeconomic policy calls for proactive fiscal stabilization, more investment, and higher neutral rates.

In a stable economy with low rates, more public investment in good times is stronger macroeconomic policy. First, governments can take advantage of low rates to make deeper, more durable investments in future productivity—in physical infrastructure and in people—that raise potential GDP and create positive spillovers. Second, funding public investment by taxing the wealthy and large corporations can reduce demand deficiency, spur growth, and raise the floor for neutral interest rates, which gives the Fed more ability to respond to recessions.

This first rate cut is a test: It’s testing whether the basic precondition of deficit hawks’ latest arguments hold and whether they have a plan to adapt to low rates; ultimately, we’ll learn if the argument was ever genuine, or if raising taxes on the wealthy remains off the table in their deficit formulations.

If You Ask Eleanor 

“Sen. Taft says that if all the President’s proposals are adopted we will spend ten billion dollars a year more than we are now spending. And he asks, “Where is this money coming from?” He evidently missed a paragraph in President Truman’s message which said: “Many of our families today are suffering hardship because of the high cost of living. At the same time profits of corporations have reached an all time record in 1947 … $17,000,000,000 after taxes.” 

Somehow I think the money can be found if it is really necessary for the good of our nation to put these measures into operation.”

– Eleanor Roosevelt, If you ask me (January, 1948)