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Deficit, U.S. Default, and Economic Stimulus versus Austerity

By       Message Seymour Patterson     Permalink
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Observing the political chatter surrounding 2012 presidential election, it becomes increasingly clear how stark are the differences between the candidates. On the basis of his actions President Obama prefers a more stimulative agenda for the economic recovery through more government spending and tax cuts--although he wants to repeal the Bush tax cuts for the top 1 percent of the population. Yet, the unsung story is that he has cut taxes on the middleclass, (See: click here=1) and staved off the lurch of the country over the economic precipice. Action is often informed by faith. In this case, spending (aggregate demand) drives the fate of a mature modern economy such as ours with an historical growth rate in the neighborhood of 3 percent, and whose economic engine, which is sputtering, pumps out a reliable output of over $15 trillion annually. Despite alleged ineffectiveness--i.e. the stimulus failed, some republican governors and mayors have made public utterances to the contrary. These include Tulsa, OK Mayor Dewey Bartlett said about the Recovery Act, "it worked," (See: click here) and t he former governor of Florida said that the stimulus worked, it created "87,000 jobs, 27,000 of these jobs are educators and teachers throughout our state." (See click here) Yet, governors including republicans accepted stimulus money, although not a single republican in the House voted with the majority for passage.

The recommendations for implementing stimulus policies don't come out of thin air. They emerged from the minds of elite economists, a notably famous contemporary one is Nobel Prize recipient Paul Krugman who argued that Obama's stimulus spending was timid ("not big enough") (See: click here) and as such could not do the job. The speaker of the House and the minority leader in the Senate, plus several states governors weren't going to give the stimulus package any chance of working ; for to do otherwise would put to the lie their argument that stimulus spending does not work. Even Mitt Romney at a very uncharacteristic moment said spending cuts could cause a depression. In his own words, "Well because, if you take a trillion dollars for instance, out of the first year of the federal budget, that would shrink GDP over 5 percent. That is by definition throwing us into recession or depression. So I'm not going to do that, of course." (See: click here)

I don't know whether deficit hawks and Tea Party members believe that the 2007-2010 recession was caused by the U.S. deficit (and debt). But they ascribe to the notion that taming the deficit is the path to economic recovery. This is the position the Tea Party standard bearer John Boehner assumes. He threatens not to agree to a hike in the debt ceiling (and risk default) if the administration does not cave to his deal, which is for every one-dollar increase in the deficit, there has to be a corresponding one-dollar decrease in the debt. The line of causality from here is deficit reduction, which leads to certainty (confidence if you will), incentivizing investment, which results in economic growth.

These are the two arguments: Deficit spending versus deficit reduction. And they arrive finally at the same place through investment.

Krugman: Recession is the result of insufficient demand.

Response: Run deficits to add demand to the economy, in response businesses will invest, and economic growth follows.

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Tea Party: Recession happened because the deficit is out of control

Response: Cut the deficit, this creates certainty, which induces more business investment, which leads to growth.

In the deficit-increasing model, tax cuts are legitimate because they lead to higher demand. So it would be okay with a Krugman to cut taxes and/or increase spending, which leads, of course, to higher deficits. And that is because in bad economic times we need deficit spending. Deficit hawks disagree. From their perspective, deficit reduction is paramount, but tax increases are out of the question. True. In bad economic times, no one should want to raise taxes that would be counterintuitive. But Tea Party members have no objection to cutting taxes that would increase the deficit they argue adamantly must be reduced. This is not a small conundrum. For , to simultaneously cut spending and taxes would necessitate cutting spending at a higher rate than cutting taxes. Giving people a tax cut will lead to an increase in demand by less than the amount of the tax cut--people will likely save part of the increase in their disposable income from the tax cut. But a cut in spending causes a drop in demand equal to the amount of the spending cut. For instance, suppose the government cuts a trillion from the budget. That is a trillion of lost demand that Romney said could lead to a depression. Now, suppose, too, that at the same time there is a tax cut also of a trillion dollars, but only 90 percent of this cut goes to increasing demand in the economy. The result the deficit has not been reduced. The net effect of this is a loss of demand of 10 percent, or $100 billion. That might be an economic outcome you don't care about. If you want a deficit reduction from this tax and spending cut scenario, the government would have to cut spending by say, $1.1 trillion. This would guarantee a $100 billion reduction in the deficit, and an overall loss of demand in the economy of $200 billion. Boehner might register glee over the deficit reduction and indifference over the loss in demand and the ensuing rise in unemployment. To his credit, Romney might be appalled.

The tax cut story does not end here. Apart from saving parts of tax cut moneys, there is a view out there in academia that tax cuts might not have the stimulative effects one might hope for the economy. The reason is that people tend to believe that when the government cuts taxes, they expect the government to reverse itself in the future and raise taxes again. So they save for this eventuality. Of course, Tea Party activists believe addressing the deficit by cutting spending will not (never) require raising taxes again. If this assertion could be codified, then tax cuts might have a stimulative effect on the economy by increasing disposable income. But the question is how do you ensure taxes do rise--sign the Grover Norquist pledge to never raise taxes (some of the signers of the pledge are having seconds thoughts, however), or amend the constitution such that Congress can never ever raise your taxes again. Or , repeal the 16th amendment that gave the government the authority to tax and as a symbolic gesture get rid of the IRS. This might be a visual clue, the kind of certainty that says taxes will not be raised in the future.

In my view, the jury is still out on the efficacy of a sledgehammer approach to the economy whether historically from the IMF experience in Africa or more recently the EU's in Greece. I think advocates of draconian fiscal policy measures conflate the household with the state. You know, "if a household or firm lives above their means soon it will face disaster'--bankruptcies and foreclosures. The firm has to downsize, restructure, renegotiate debt, and may even get help from Bain. But the state is not a business firm: it cannot downsize. When it attempts to downsize you get Greece, Spain, France, and the UK. Downsizing means laying off thousands of Greeks, Spaniards, Frenchmen, and Brits. Real people; real lives go kaput. Students are told to go home because they can't afford higher tuitions, dimming the prospects for their future. Incidences of depression, suicides, physical illnesses, and crime rise. All because the financial wizards responsible for the great recession and the politicians in bed with them wish to focus attention of deficits--balance sheets and financial statements--rather than on real things like job maintenance and economic growth. Given a choice between more deficits and more unemployment, deficit hawks would choose more unemployment. Whack $1 trillion in government spending, the economy spirals down 5 percent (Romney speaking), and unemployment rises from 8 percent to 10 percent. Cheshire Cat grins appear on the faces of deficit hawks and a bunch of state governors. A superior strategy is the one based on economic growth. For , if the country's real resources (workers) can grow the economy, then deficit growth is sustainable. A country's whose debt is growing at 5 percent and whose income (GDP) is growing at 8 percent doesn't have to lose much sleep over its rising indebtedness. Suppose, however, this rise in indebtedness causes panic, and the government reduces the growth rate of the debt to 2 percent , then the economy is catapulted into a recession and unemployment rises. GDP growth is now zero and the growth in the debt is 2 percent. The debt has not been paid down. It is still growing. Great going! The absolute size of the debt is a nonissue and from Dick Cheney (in a self-serving moment), we know deficits don't matter. Here's what he's alleged to have said: "O'Neill said he tried to warn Vice President Dick Cheney that growing budget deficits-expected to top $500 billion this fiscal year alone-posed a threat to the economy. Cheney cut him off. "You know, Paul, Reagan proved deficits don't matter," he said, according to excerpts. Cheney continued: "We won the midterms (congressional elections). This is our due." A month later, Cheney told the Treasury secretary he was fired." (See: click here)

In the final analysis, what really matters is the country's ability to service its international financial obligations. And it does this by growing; by employing its people.

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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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