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The 2012 Presidential Election a Referendum on Stimulus versus Austerity: Who's Right (or Wrong) Obama or Romney?

By       Message Seymour Patterson     Permalink
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Short-Term Fixes

Mitt Romney has said that when he is president he will reduce the jobless rate to six percent. Of course, that is better than the current rate of 8.3 percent. But what will that mean in terms of the economy performance going forward? There is a formula (namely, Okun's Law) that can help us tease out an answer to the relationship between GDP growth and unemployment rates. Okun's law states that for every one percent increase in cyclical unemployment (difference between actual and full employment rates), GDP decreases by some constant (2 percent). Suppose Romney gets the electoral college nod, and the next day, hypothetically speaking, the unemployment rate falls from 8 percent to 6 percent, a drop of 2 percentage points (same as Obama), that would spur GDP growth by 2 time 2 percent; again the same as Obama. Thus, it is harder to make the case why Obama should be replaced.

There exist multiple approaches or competing views for rescuing the U.S. economy from the 2007-2010 great recession, but two views have gained currency, in part, from what is happening in the EU, and from the coming presidential election in the U.S. The first is the stimulus approach followed by the Obama administration, and the second non-stimulus (austerity) approach adopted by the challenger. These two approaches are not mutually exclusive arguments. They both assume that investment would eventually be the catalyst to growth. Obama believes the collapse in private sector demand caused the recession the aftermath of which he is grappling with and that government stimulus in the short term can replace that lost private demand. The expected response to the stimulus, the demand generated by government spending (i.e. deficit spending) private sector firms will produce more, and to do that they would need to hire more workers, thus reducing the jobless rate. This is core of the Keynesian model that enjoys both evidentiary credibility and sustainability--it's been around for a long time. The president implemented some of the model's provisions, albeit, modestly, which might have worked by preventing the economy from going over the recession cliff. The problem, if I might dare say, is reluctance to "Stand Your Ground." He vacillates under pressure from the opposition, the people who have expressed no desire to compromise with him--House Speaker John Boehner and Senate Minority Leader Mitch McConnell. They might have got their marching orders from Rush who boasted after the 2010-midterm elections, "winners don't compromise with losers," and prior to that he said, "I want [Obama] to fail." On the other hand, Gov. Romney maintains that the looming U.S. government budget deficit (and the national debt) is the problem (i.e. that caused the 2007-2010 great recession)--this ignores the ripple effects on the U.S. economy (and indeed the global economy) of the seismic financial fallout (and the housing market collapse) of such erstwhile stalwart giants like Lehman Brothers and Woolworths in 2008; Merrill Lynch was gobbled up by Ban of America for a mere $50 billion; AIG, being to big to fail, meant Uncle Sam had to become its majority owner (holding 80 percent of its stock); and Fanny Mae and Freddy Mac are now government owned institutions. This begs the question, what's the solution? Romney's solution: massive cuts in government spending--including police, teachers, firefighters, plus higher-end income tax cuts--to restore public confidence in the government: confidence, which some people believe would lead to renewed private investment and economic growth, without the need to raise taxes in the future. Obama's solution: more government spending and tax cuts to stimulate total demand in the economy.

By and large, it seems stimulus plans are a nonstarter around the world but mainly in the EU where austerity is the name of the game. The problem with austerity is it is the wrong pill for the wrong ailment. Deficit hawks assume that deficits cause recessions. Hence, austerity is the remedy. I have not aware of evidence for this. On the contrary, recessions cause deficits--there's lots of evidence and intuition for this. So, the remedy is transparent, correct the recession and you fix the deficit.  For an empirical test of cuts--austerity--look no further than MP David Cameron's Britain: it has not made them better. (click here) The Eurozone demand for austerity (led by German Chancellor Merkel as conditions for bailouts) has been met with massive demonstrations in Greece and Spain. These demonstrations are not an argument against austerity, which can have dramatic effects on people livelihood. They are reactions to an assault on a way of life. But more broadly, I am yet to discover evidence that austerity works. Even the French populace reacted to less than draconian austerity prospects by handing President Sarkozy a pink slip, i.e. he lost his job to the socialist Francois Hollande, who is not likely to pursue austerity as a policy.

Secular Issues of Concern to the U.S.

Given the stellar performance of the Chinese economy in recent years, this hybrid system of communism cum market economy will overtake the U.S. as the world's leading economy in a generation, if the current rates of growth of the two countries continue unchanged going forward. More to the point, in terms of sheer size, the U.S.  economy is gargantuan. Its annual output of goods and services is approximately $15 trillion (or $14,582.40 billion) and its growth rate, 2 percent. But the U.S. average economy growth rate from 1948-2012 is 3.23 percent a year. Restore this 3.23 percent growth rate of GDP, and we can stave off the Chinese challenge a little longer. The People's Republic of China by comparison puts out roughly $5,878.63 billion or $5.8 trillion annually (2011). The Chinese economy grew at 8.1 percent (2011), according to Trending Economics. (click here) With the caveat that nothing changes, a simple calculus would reveal the exact year when the two economies will converge.

At first blush, you would think there is no way China will catch up to the U.S. given it is only a third as large. But China is growing by a factor of four faster than the U.S. and that makes a tremendous difference. Here's a familiar high school math example: suppose a goal post is 12 miles away from the starting line and there are two runners A and B. Runner A can average 2 miles an hour and runner B, 4 miles. Runner A is 4 miles from the starting line at the start of the race. The race starts at 1 p.m. At 2 p.m. runner A is 6 miles away and runner B is 4 miles away. And at 3 p.m. both runners are 8 miles away the finish line. But at 4 p.m. runner B is at the finish line, while A is 2 miles behind. This is the kind of race the U.S. and China are running, with the U.S. ahead by a factor of five in terms of GDP. With a smidge of math for jiggling the numbers we can come up with a date when the two countries' GDPs will converge.  The answer is 14.89 years! Or, starting from 2011, conversion will occur in approximately 2026.

Is this good or bad? I think about this often. Plato said, "Man is the measure of all things." This seems an oblique way to say we (he probably meant the aristocracy) determine right or wrong, good or bad. The answer to the question was echoed by the playwright Shakespeare in the voice of Rosencrantz babbling to Hamlet, "There is nothing either good or bad, but thinking makes it so . . ." in the play Hamlet. If we drill down to the world of quantum physics we find that things (electrons) can be different things at the same time. In terms of the peculiarities of quantum mechanics where a particle (an electron) can be in two places at the same time, the 'Schrodinger's cat' comes to mind. Economists try sometimes for more certainty than philosophers, playwrights, and scientists in the world of quantum physics where probabilities reign. Even economists who are fond of quantitative analysis can be frustrating admitting that truth might not be absolute.

First the Good!

I have always maintained that if a country wishes to give away its labor, capital, and technological resources embedded in its products by dumping them on a foreign (our) market, I would cheerfully accept their gift, and then I'd dash to my computer and fire off a 123Greetings card to thank them. Giving away its resources is precisely what China does when it devalues the Yuan to make its goods cheaper in terms of dollars. Send them "a thank you note. But some of our politicians complain that China's outstanding performance can be traced to us trading with them on a tilted surface where their goods are favored over ours in exchange. And that the cheap (devalued) Yuan is one enables this. Nevertheless, with devaluation I need fewer American dollars to buy the same amount of Chinese products. I'm happy.

Since with this scenario, the Chinese sell more of their goods to us than we sell of ours to them, they are accumulating lots of U.S. dollars, which they have employed in the purchase of U.S. government interest bearing securities, i.e. U.S. government bonds by the tune of $1 trillion--$1169.9 billion worth as of March 2012. Well, if I were the U.S. government, I would be begging the Chinese or anyone else willing and able to buy my securities to take them. Why? Because the interest (coupon) rates on the bonds are in the basement. Then add a dash of inflation, and the real interest payment obligations on U.S. government bonds are very low by historical standards. One final point, with all the dollars out there in circulation, it is only a matter of time before inflation rears ugly its head, and the U.S. government will be paying back it lenders including the Chinese with cheaper money in terms of purchasing power.

Next the Bad!

Devaluation is like a two-edged sword. When China devalues the Yuan U.S. goods become more expensive in terms of the Chinese currency, so we sell less of our goods to China. Two things are occurring here, American manufactures find it difficult to compete in the international market, Chinese market, and have to cut back on production at home, and they are forced to fire some of their workers. Generally, this is not good for the American economy. The export sector of an economy is likely the most efficient in utilizing that country's relatively scarce resources. Thus, the loss of foreign exchange earnings from devaluation means the U.S. can finance few imports from China. Now, instead of buy Chinese goods, we resort to producing them ourselves with the help of some trade barriers--import tariffs for instance. Some people would say, "Good for us!" But not so fast with the self-congratulatory speeches because this means you (the U.S.) will be redirecting it resources from the most efficient use (export sector) to the least efficient use (import replacement sector). On the other hand, the Chinese economy benefits from this and gets even stronger. Its industries that export goods the U.S. market benefit from devaluation and can export more. These industries can now hire more Chinese workers, and thus, continue to grow the Chinese economy. The Chinese export earnings will give them a greater command (a larger share of U.S. output) in coming years. This could exacerbate the trend in the direction of expected Chinese economic dominance.

The Wrap

A decade and a half, 14.89 years, is a quasi-long time. In fact, I posited initially that in that timeframe the Chinese economy would overtake the U.S. economy if the current rates of economic growth carry over into the future. However, anything can change in the interim. Unforeseen events always lurk in the shadows and can pounce on the unwary with lightning alacrity: a war--with Iran (Bill Kristol gets to bomb Iran--(click here)--an Arab Spring reprise, an unanticipated recession, hostilities with North Korea over their nuclear weapons program. More farfetched events occurring: the Mayan calendar is true (and December 21, 2012 is the end--apocalypse), or Asteroid 2012 DA14 approaches the earth maybe too close for comfort in 2020; and God forbid, global warming might be real. These are all potential game changers. But, alas, I'm being an irresponsible alarmist. I apologize. Yet, anything [everything] can happen and change the trajectory of history with consequential outcomes for the balance of economic power.

Fixing the economy should be our number one priority. Assuming none of the calamities described above happen, then in a sense, the coming presidential election in November 2012 will be a referendum on which of the two approaches for mending the U.S. economy is preferable in terms of economic viability--stimulus (more government spending) versus austerity (less government spending). Some ongoing political bickering over which solution is right (versus wrong) is inevitable. Right or wrong (stimulus or austerity), these prescriptions are essentially short-term fixes. But the U.S. has long-term structural issues such as the loss of economic hegemony worldwide due to China's coming of economic age and U.S.'s ethnic transformation due to a higher minority birth rate propensity. As alluded to earlier, there is a possibility that China will overtake us in 2026. Add to that the fear of the browning of America circa 2050. These two events of near simultaneous occurrence in the grand scheme of things might play such havoc on some people's psyche that we might need to construct a padded fence around us to keep from doing ourselves harm--from ethnic tensions and Sino/U.S. commercial hostilities.

 

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Seymour Patterson received a Ph.D. in economics from the University of Oklahoma in 1980. He has taught courses and done research in international economics and economic development. He has been the recipient of two Fulbright awards--the first in (more...)
 

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