Jul 15, 2011 at 11:43 pm
Q: How can we –Rs and Ds alike – now be assuming that deep cuts are what this economy needs? Are people assuming spending cuts will be expansionary? Is there any sound economics backing this up? Or is it just confidence fairy stuff?
A: For some it’s confidence fairy dust, but for others, there are a few academic papers that claim evidence in support of the idea that spending cuts are expansionary. But the evidence is very weak and certainly doesn’t apply to the current conditions here in the US.
Here’s my review of an excellent paper challenging this idea of expansionary contractions (EC…sounds like giving birth). Note the figure which shows that in the past, any spending cuts associated with growth occurred in economies that were pretty much back to full strength.
The nation’s premiere expert on the fallacy of EC is my CBPP Chad Stone. See his testimony before Congress and why this qualifies as the new voodoo economics.
I always come back to the fact that GDP equals private consumption and investment, plus net exports, plus gov’t spending. In the full employment economy, you can tell more complicated stories about gov’t spending crowding out private borrowing. But in today’s economy and that of the near future, the private sector components of that equation aren’t helping much. Cut G (gov’t spending), and I guarantee you, nothing good will come of it.
It’s really that simple.
Q: Why, during the financial crisis, were Treasury and the Fed adamant about protecting debt holders?
A: Not all debt holders. Lehman failed and creditors lost money, and bond holders in the GM and Chrysler also “took haircuts” during the government take over.
But in general, debt holders were held relatively harmless for two reasons. One, to avoid generating high risk premia on loans. If creditors think there’s a chance they’ll get stiffed, they’ll want protection and we did not want to see interest rates spike then anymore then we do now.
But more important is fear of contagion. This is certainly the case in Europe right now, where rather than address what looks to me like Greek insolvency, the bankers of Europe are calling it a liquidity crisis, pumping in loans, and protecting lenders. Well, those banks hold a lot of Greek debt (about 50% of it) and some of their books could look pretty thin if they took writedowns.
I’m not saying I agree. There are times when it’s better to rip off the band aid and accept that defaults and restructurings are part of life under capitalism. But I will say, with hindsight, I think the evidence supports the view that Geithner played it correctly.
But I’m not nearly so sure that’s the right play with Greece.
Q: What confuses me is the idea that we first take care of the deficit and then we can focus on jobs. But wouldn’t any effective Keynesian jobs program call for more deficit spending?
A: That’s confusing because it’s backwards. In the short term, i.e., now, the economy is practically on its knees, begging us for short term stimulus to boost job growth. And yes, it would call for more spending.
That spending would be temporary, and thus would have virtually no impact on the medium or long-term deficit, nor would it add anything to the growth of the debt. The Recovery Act was $800 billion of deficit spending, and look how its impact on the deficit becomes de minimis by 2013.
That doesn’t mean we ignore the fact that the current budget path is unsustainable, meaning that even with a recovered economy, what we take in and what we spend are so misaligned that each year, debt would still be rising as a share of GDP (i.e., “structural” deficits).
But the key is to get the sequencing right on this. Plot the sustainable path now but don’t start down it until the economic recovery truly takes hold.
BTW, Greg Sargent has an interesting analysis of the President views on this question from his press conference today. Obama’s analysis is more political or optical then Keynesian—basically, he’s saying that generating some serious deficit savings gains you the trust you need with the public to do some stimulus.
Sargent points out there may be something to that approach:
“Once Clinton restored his credibility with the middle of the country…he was able to pick (and win) major fights over the proper role of government and the safety net that set back the GOP drive to dismantle government for a decade.”
I agree but again…sequencing. This is demonstrably NOT the time to show you can whack away at the near term deficit.
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