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A New York Times article today rehashes the conventional myths about deficit spending : that it is inflationary and dangerous, and that its use in extremis today must be carefully reversed in the future, lest it lead to foreign countries dumping US Treasuries and causing a cataclysmic increase in the US interest rate. The author seems to think that, because reckless borrowing and spending by Americans precipitated the current crisis, more borrowing and spending on a larger scale by the US government cannot possibly be the cure. In doing so, the author displays more than a few misconceptions about economics (such as confusing micro and macroeconomics), and contributes to the economic illiteracy of the reading public. Firstly, deficit spending is not intrinsically inflationary. Secondly, even if all foreign countries simultaneously dump all of their Treasuries, the interest rate will not rise an iota if the Fed doesn’t want it to rise.

Inflation occurs when the monetary base grows faster than the amount of goods and services in the economy. Deficit spending, applied to boost consumption, will result in inflation because the amount of goods and services in the economy is unchanged while the monetary base is increased. On the other hand, deficit spending applied to boost production will increase the amount of goods and services, and is not necessarily inflationary. It is true that traditional Keynesian macroeconomics theory calls for the use of deficit spending to boost “aggregate demand”, but I am convinced that the theory thus applied will fail, as Japan has illustrated with its failed fiscal policy to boost consumption in the 1990s. The only thing that pro-consumption fiscal policy has going for it is its speed of effect; it is easy to boost consumption quickly, it is much harder to boost production quickly. However, the infrastructure projects currently envisioned by the Obama administration is in many ways the best of both worlds. Infrastructure improvements take time to impact production levels, but their immediate effect is to employ large numbers of people who will boost demand right now, when prices are falling due to deflation. Hopefully, by the time the economy recovers to the point that inflation is a concern, the productive nature of the infrastructure investments will kick in and help limit inflation. Also, boosting domestic production will reduce US reliance on imports, which will make it less important if foreign countries stop buying US bonds. Lastly, the Fed can print money to buy up any amount of Treasuries dumped in the open market, sharply limiting any effects on the interest rate, and can in fact substitute for any drop in foreign demand for US bonds. In general, the media should pay less attention on the total amount of stimulus spending, and more attention on how the money will be spent.

How can the stimulus money be productively spent? Three major areas occur to me, energy infrastructure, internet infrastructure, and education. Currently, US cities along the coasts burn oil and coal to generate electricity, while further inland, electricity can be generated cheaply from renewable resources such as wind generators and dams, prompting energy-intensive industries such as data centers and aluminum and steel mini-mills to relocate to those locations. Electricity transmission lines are regulated and maintained at a state level in piecemeal fashion by the electricity producers themselves, who understandably are not going to commission the construction of inter-state transmission lines which will disrupt their local monopoly. The government can step in to construct a cohesive national electricity transmission network, which will equilibrate electricity prices throughout the US, and probably reduce America’s reliance on imported oil for electricity generation. A similar failure of market forces is occurring in internet infrastructure, where the US lags many other countries in broadband penetration. Lastly, education is a silver bullet which, in addition to adding to human capital, has many beneficial social benefits such as lowering the crime rate and facilitating better political decisions. Unfortunately, an unnecessarily large number of young Americans drop out of the education system every year, and in general, Americans are under-educated, especially in math and sciences, to the point that the US computer and biotechnology industries require a large influx of highly trained foreigners annually for them to function. A lot can be done to change this situation. Many countries require teachers to pass stringent exams and be licensed. In return for a large increase in pay, American teachers should be required to pass both written and practical licensing exams, similar to the licensing process that medical doctors go through. Statistical tracking of student achievement should be vastly expanded and standardized at the federal level, so as to properly measure the ability of teachers and the improvement of students. A new initiative to expand educational research among social scientists should be considered. Schools should be safe and palatial, with facilities to accommodate students who need a refuge from their turbulent family life after school hours. Meals should be provided free and on a need-blind basis. While I realize that many of the proposals above are not politically realistic, the achievement of at least some of them will go a long way towards boosting the future productivity of the USA.

How can the stimulus money be mis-spent? The Obama administration is unlikely to use another tax rebate to boost consumption. Japan’s experience with issuing shopping vouchers to citizens has shown that when companies recognize that the demand boost is a temporary phenomenon, they do not hire people or expand production. Another tax rebate is likely to be saved, or be used to buy imported goods, and hence will not stimulate the US economy by much. A more likely scenario is a government subsidy for house purchases or refinancing, perhaps by issuing government backed housing loans at a below-market interest rate. This development would be troubling to me, as I frown on consumption-boosting stimulus efforts. In my opinion, the government should not be trying to influence consumption patterns through its policies. US politicians seem to have a penchant for promoting house ownership, believing that somehow this will give people a stake in the economy and help them save up for the future. In practice, owning a house makes little sense for someone who may move in a couple of years, as the transaction costs involved are huge and will likely eat up any capital gains. In fact, excessively high home ownership levels make it difficult for people to move to where jobs are, making the labor market more inflexible. Businesses routinely operate with long-term operating leases on buildings and properties without the need to own them outright, even though it can be argued that a business is more likely to have a permanent presence in a certain location compared to a person. Still, the government will be sorely tempted to try and stabilize the balance sheets of banks and the psyche of the American public through targeted inflation of housing values.

In short, there is good deficit spending, and bad deficit spending. The US government should concentrate on getting the most productive bang-for-the-buck with the stimulus money, and immediately start all currently feasible productive infrastructure projects. Everything else is just noise, including predictions of pending inflationary doom and reactions of foreign governments. If the government invests the stimulus money correctly, the other side-effects will sort themselves out.