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The Looming Deficit Disaster, Modeled

Yale's Ray Fair, well-known for his economic model predicting the outcome of presidential elections, has a new forecast out on the macroeconomic effects of large budget deficits -- and it's not pretty:

  • A depreciation of the dollar leads to inflation, as expected, but this is of only modest help regarding the debt problem. It does not appear that the United States can inflate away its debt problem. The picture is worse regarding output if there is a flight from U.S. stocks as well as the dollar.
  • Personal income tax increases and transfer payment decreases have similar effects on the economy. A tax increase or spending decrease of 4 percent of nominal GDP is enough to solve the debt problem. The real output cost is about $300 billion per year.
  • A national sales tax is more contractionary in the model than are personal tax increases and transfer decreases...A national sales tax thus does not look like a good idea, although there is more uncertainty here regarding the ability of the model to deal with this case.
  • The effects of interest rate changes on the economy are not large enough in the model to have the Fed come close to offsetting the effects of shocks. For example, much of the output costs to tax increases or spending decreases seem unavoidable.

Fair's model, which has it roots in the large-scale aggregate models pioneered by the Cowles Commission, differs fundamentally from the state-of-the-art DSGE models that the rational expectations revolution of the 1970's helped bring about. Fair has another new paper where he compares his model to the new breed and argues that the old way of doing things was less theoretically restrictive.  It's worth a read if you can wade through all the technicals. Still, we shouldn't forget that Cowles Commission-style models were originally discarded  because they failed to predict the economic gyrations of the '70s.

Meanwhile, over at VoxEU, Dirk Bezemer makes a case that the chief problem with the models used by the likes of the Federal Reserve and ECB is not that they assume rational expectations, but that they don't properly account for the impact of the financial sector on the economy:

If the crisis and recession teach us one thing, it is that the financial sector is just as real as the “real economy”. We economists – and the policymakers who rely on us – ignore balance sheets and the flow of funds at our peril.