Two prevailing different economic paradigms share an initial intersection and then depart along paths that end in diametrically opposite venues. Contemporary economic thinking is based on certain assumptions about the economic infrastructure of the U.S. and the EU countries; namely, that deficits are bad and high-debt-to-GDP ratios are deadly for countries that incur them. Out of the economic catastrophe of the Great Depression of 1929 emerged economic models that were intended to provide the framework for the restoration of the country's economic health. A salient component of the thinking elevated the role of government in the affairs of the economy. Over time, government came to occupy center stage in the play to mend a moribund economy. Fiscal policy became the instrument of choice to regulate economic performance.
Perhaps, beginning in 1929, deficit spending was not seen as the evil it is perceived to be today. Rather, it gained traction until the 1980s as the informed solution to lagging economic performance. Words such as automatic stabilizers, leading and lagging indicators, taxation, and government expenditures became part the economics discipline's lexicon. Fiscal policy was triggered when the economy was either running too hot or suffering from sustained reverses in employment and output, precipitating negative GDP growth. Fiscal policy could tack against the wind of economic fluctuation and return the economic to its natural growth profile of three to four percent long-term growth rates. The enshrined position of government started to lose luster in the late 1970s, but more prominently when President Reagan uttered the seminal statement (The Heritage Foundation): "Government is not the solution to our problem; government is the problem." Events in the 1970s lent credence to this assertion before he uttered those words. For instance, faced with stagflation, President Nixon implemented wage and price controls to combat it, but President Ford resorted to tax increases and reductions in government spending as the solution. The OPEC oil crisis (1973-1974) (Office of the Historian) with its oil shortages and long queues at the pump was part of the decade's malaise, and President Carter's failed hostages--the Iran hostage crisis (1979-1981)--rescue attempt only certified in the minds of Americans the impotence of government to solve problems. It also convinced some Americans that government needed to be shrunk (and "drowned in a bathtub"). In addition, some factions of the political class started to pontificate rather successfully that the role of the government had to be banished or at the very least truncated and private players (businesspersons)--whose raison d'Ãªtre is the quest for profit--should replace government. This view continues to strengthen, gaining momentum in the movement to privatize the functions of government, including public schools, prisons, social security, Medicare, and so forth. I contend that every popular movement, thought, or activity has a singular shelf life. Look around you: nature loves alphas and omegas, geneses and apocalypses. The morphing roles of government again attest to this. Thus, it is hardly surprising that we are no longer enamored with government, and we now yearn to shrink and drown it.
A simple line of causal connections can schematize the bad-government paradigm. Given an existing problem--say, a recession or a depression--that triggers fiscal policy for economic manipulation. Consumption, as a fraction of our $16 trillion national income, is approximately seventy percent. Bad times hobble consumption spending inasmuch as people lack income, having lost for the most part their jobs. Payrolls and income taxes -- that is, government revenue -- decline. However, almost simultaneously, government spending rises from outlays on unemployment compensation, and on social security benefits, which temper the cutback in household spending on consumer goods. Next, the impact of less consumer spending hurts business investment. Businesses have no incentive to invest in new plant and equipment to produce goods they cannot sell. On two counts, then, in a recession the deficit grows: (1) the reduction in tax receipts and (2) the automatic increase in government spending, both due to the rise in the jobless rate. The deliberate legislative implementation higher deficit to thwart a depression is contentious. The president and Congress have to agree on legislation to increase government spending and/or to cut taxes, causing the deficit to widen. Let's call this argument the deficits-are-good paradigm.
Today, we frown on deficits that spawn wasteful confrontations between members of Congress and the president on cuts in government spending (which is about 20 percent of GDP). The kerfuffle led to sequestration, a government shutdown, and a ratings downgrade of the United States for the first time in its remarkable history. One has to hope that the fallout from the intransigence of a dysfunctional government is evidence patriotism -- and not a foolhardy, and determined self-serving effort to damage government, i.e. Congress and the White House, both of which merit dismal public support. Malice can be removed as a motivation for contentious policy and if the economy suffers chalk it up to collateral damage.
Total national saving is the sum of private and government saving where the latter is the difference between tax receipts and government spending. Then when some politicians demand deficit reductions, they have in mind that deficits reduce the supply of loanable funds and raise interest rates, which harm investment. This explains why advocates of a balanced budget adamantly refuse to increase taxes one iota, and insist on reductions in government spending, which would reduce interest rates and encourage private investment. Tax credits for businesses would also incentivize more business investment. But expanding the deficit puts the government in direct competition with the private sector for loanable funds: Interest rates rise and investment falls. Higher deficits are counterproductive in a recessionary environment by causing business confidence to wane. Let's label this argument the deficits-are-bad paradigm.
Does the deficits-are-bad trump deficits-are-good argument? This is an empirical question: there's no clear evidence that in practice deficits are bad and austerity does not necessarily lead to sustained economic growth. In fact, there's evidence spending cuts can restrain growth.