If we go back to the original theory of Keynes, yes there was deficit spending but it was supposed to be largely offset by running surpluses during good times. Thus, through the entirety of an economic cycle, the debt was supposed to remain roughly flat. In other words, under the original theory, while there would be deficits in any given year, there wouldn't be much debt accumulated over time. In other words, the target deficit on average through an economic cycle was zero.
Several years ago, the terrain began to shift and budget theorists and politicians began to talk about the notion of "primary balance." This notion is simple, namely that the budget is in balance with the exception of debt service. What this means is that the budget deficit is equal to or lower than interest on the debt. Since interest payments currently run about 1.5% of GDP, the notion of primary balance would imply running deficits under this level. Note, this notion abandons a balance through cycle and proposed continued perpetual deficits, but small ones.
More recently, we've abandoned that notion as too restrictive and now begun to argue that deficits are fine as long as they don't grow the debt to GDP ratio. Now this is even a higher standard of how much deficit is good since GDP generally grows faster than the 1.5% that current debt service accounts for. This latter standard is the standard that is commonly in use among more liberal economists today such as Paul Krugman or the CBPP.
But until recently, I thought primary balance was a through cycle view just like the original Keynesian view. But, based on this piece by Dr. Krugman today, I'm beginning to understand my error. Krugman writes
Recently the nonpartisan Center on Budget and Policy Priorities took Congressional Budget Office projections for the next decade and updated them to take account of two major deficit-reduction actions: the spending cuts agreed to in 2011, amounting to almost $1.5 trillion over the next decade; and the roughly $600 billion in tax increases on the affluent agreed to at the beginning of this year. What the center finds is a budget outlook that, as I said, isn’t great but isn’t terrible: It projects that the ratio of debt to G.D.P., the standard measure of America’s debt position, will be only modestly higher in 2022 than it is now.So in the view of Paul Krugman and the CBPP, it's OK to do nearly nothing because the debt to GDP ratio (proclaimed the standard measure of the US debt position) will not increase very much between now and 2022.
The center calls for another $1.4 trillion in deficit reduction, which would completely stabilize the debt ratio; President Obama has called for roughly the same amount. Even without such actions, however, the budget outlook for the next 10 years doesn’t look at all alarming.
But let's take a look at what the CBO expects from the economy over the 10 year period...in short rapid growth, full employment and low inflation for about 8 of the 10 years. So the new standard is that slowly growing the debt to GDP ratio in an era of full employment is OK.
We've gone from saying we should run a surplus (Keynes) in good economic times to saying that it's OK to run a deficit of 3 or 4% of GDP, a rate that has rarely been seen outside of wars (Krugman). My how the mighty Keynes has fallen. One almost wonders whether he'd recognize himself in his newest incarnation.