The limit of stimulus

The battle over stimulus has shifted. The curmudgeonly neoclassical economists - who think that recessions are caused by us suddenly forgetting how to make cars, etc. - have retreated to their caves, and those who say Obama's stimulus had no effect are looking less credible by the day. The fight is now over future stimulus. The battlefield is divided between those who say "We need more stimulus because we're still not out of the liquidity trap," and those who say "The debt burden of additional stimulus is too high."

Representing the former viewpoint, we have Paul Krugman:

The basic economic logic says that the stimulus should aim to close the output gap. And it’s obviously not remotely large enough to be doing that right now. Nor will it come close in the future....

[W]hile most of the stimulus has yet to be spent, the rate of spending as a percentage of GDP is already fairly high...That means that we’ve already seen much if not most of the impact of the stimulus on growth...

[W]e’ve gotten the big boost, and it’s clearly far short of what we really need.

And yes, we can afford more.

Most standard economic models say: As long as nominal interest rates are 0 (which they still are), stimulus spending boosts GDP. So we CAN boost our GDP more by borrowing and spending more. The question is whether we want to. There are two reasons we might not want to:

Reason 1: We care about the future a lot more than the past. Every $1 of stimulus spending requires us to borrow $x from future generations. When stimulus spending boosts GDP, "x" is less than 1, because boosting GDP boosts tax revenues (note: this is exactly the argument that supply-siders use to argue for tax cuts; the difference is that they don't realize that the trick only works when interest rates are 0). So suppose we can boost today's GDP by $1 by borrowing 50 cents from our children. We still might not want to do that, if we care about our children a lot more than we care about ourselves. Keynes, the original proponent of stimulus, said that "in the long run, we are all dead," but he died childless...

Reason 2: We're worried about a U.S. debt default. Recessions caused by financial-system collapses can last decades. Keeping up stimulus spending for decades can lead to massive levels of debt, as Japan found in the 1990s. Even if all that stimulus spending has its desired effect, the debt burden can be so large that at some point it pushes the country into a sovereign default. In fact, this is almost certain to happen to Japan. Sovereign debt defaults are massive economic crises - GDP usually drops by double digits and never bounces back. Governments fall, poverty soars. We really do NOT want this to happen to us. If we reach the point where continued stimulus spending would push our debt over 100% of GDP, we should think twice about continued spending, even if that spending would still have an effect. To me, this is much stronger than Reason 1.

So there are good arguments out there for reining in stimulus spending. We can't brush these arguments aside just by pointing out the foolishness of the "stimulus can't work" crowd. Our children will have to carry the burdens of peak oil, global warming, and a lower worker/retiree ratio that strains their pension programs. We might want to spare them the added debt burden that more stimulus would create, even if doing so comes at great cost to ourselves. And we certainly do not want to put them - or us - in danger of a U.S. sovereign default.