Deficits and The Economy: Time To Get Worried?

The big question now has become: are we falling back into recession?

Who knows?

There is plenty of evidence mounting that the US economy is slipping back from its early recovery pace into a much lower, and therefore more risky, pace. The downward revision of first quarter GDP, from the original 3.1% to the more recent 2.7% is just one example. The stubborn refusal of private businesses to hire workers is a sure sign of that sector’s collective gloomy and fearful approach – private sector hiring is still anemic and was insufficient to offset the seasonal lay-offs of government workers brought onboard to do the census. Real estate is mired in a deep slump and shows no sign of recovery. On the contrary each report on housing seems to ring up a new historic low for activity. And even the springtime euphoria in manufacturing has now given way to a two month drop in factory business as measured by the Institute of Supply Management. US factories appear to be suffering the backwash from the Euro zone difficulties, where European austerity plans imply less imports from America.

In short nothing looks as rosy as it did back in April and May.

It is in this weakening context that we should assess policy. In particular we should take a good long hard look at the Federal deficit.

I have beaten this drum incessantly, so bear with me one more time.

Now is not a time to reduce the stimulus. Not at all.

Yes, that implies big and growing deficits. But, as I have stated many times, a big portion of that deficit is cyclical: it will go away when – and if – the economy picks up a head of steam.

And, yes, we have a definite and large deficit problem. We spend far too much on defense and on health care. We cannot afford to keep those expenditures at their current level without getting a more secure funding for them over the long haul. Our deficit problems are rooted in the insane and reckless budgets of the Bush era, not in the emergency and temporary measures of the Obama era. We need to keep that in mind as we argue over the next step in policy.

Take a different tack: if we adopt austerity measures now, or even in the next few months, the odds of a repeat recession shoot up rapidly. There is absolutely no evidence that the private sector is ready, willing, or able to carry the load. Just the opposite: businesses appear only too willing to reduce themselves in order to protect profit in the short term. This weakness and timidity sets in motion the classic downward spiral of the a ‘paradox of thrift’, which only the government can break.

In my mind the world’s leaders have gone crazy: they are all so hell bent on budget cutting in order to appease the credit markets that they have forgotten the long term consequences of their actions. They are all willing to abandon long term health for short term ‘confidence boosting’. As if the markets can’t see the devastation that could arise from this austerity mania. There is almost a collective reverse bubble psychology at work. No politician wants to be sen as ‘weak on deficits’. They conveniently forget the lessons of the 1930’s and rely instead on the economic theories of the last thirty years. But those theories are bankrupt. They were wrong when they were first floated, and they have been exposed as wrong by this crisis. Quite why otherwise intelligent people are still clinging to those policies baffles me.

Inertia?

Ineptitude?

Ideology?

All of the above.

Take the Germans: in good teutonic style they adopt austerity in order to get their house in order. They neglect to note, or admit, that their economy is built upon foreign consumption. That consumption sucks in German goods. So as long as the rest of the world is willing to remain profligate the Germans can be austere and feel good about being ‘correct’.

But: what if the rest of the world also gets a bout of austerity?

Who will buy those German goods? Not the Germans. They are facing austerity cutbacks. The austerity logic breaks down when the entire world goes in the same direction. There is no one to provide the consumption necessary to drive the world growth machinery.

This is why the Chinese have become so important.

The financial markets, and the more optimistic folks in the financial media, have been relying, in their forecasts, on Chinese – and to a lesser extent the rest of the emerging world – to maintain demand so as to allow the ‘old world’ to make the painful budget adjustments they need to without falling back into recession.

Which is why the most alarming news this week has been that the Chinese economy is showing very distinct signs of slowing down.

Get ready for a nasty shock later this year when the GDP numbers come perilously close to zero. Especially as the effects of last year’s stimulus fade away. I still expect us to eke out growth over the near term, maybe in the range of 1.5% to 2.0%. But it doesn’t take much – a Chinese slowdown and all that Euro austerity? – to eliminate it.

Which brings me to a question often asked: the pile up in US debt is presumed to have bad consequences. Especially: the credit markets are presumed to be jittery about our budget. How dow we know when the threshold is reached and the world won’t support our profligate ways any longer?

The short answer is that no one can possibly tell. The longer answer is that I don’t really care anyway.

The reason is this: with the world in a swoon, money has to go somewhere. The US is still, by far, the world’s largest economy, and it is still very stable. Yes the US has long term imbalances that must be eliminated. And, no, there is no sign that US voters will support the kind of cuts needed – can you imagine a Presidential candidate advocating defense spending cuts along with a increase in the retirement age and proper health care reform? We have just been witness to the deep rooted divisions in the US that prevent fiscal rebalancing. It is unlikely that we will succeed any time soon.

But: the rest of the world is in such bad shape that even a profligate and badly managed America looks safe. How else do we explain the drop in US bond prices? Were we reaching the threshold of pain for our creditors and early sign would be their unwillingness to buy our debt. Our bond prices would be rising. This is not happening. Bond prices are falling and demand for our debt is rising. In other words we have a huge capacity – still – to borrow.

We should use that capacity in order to guarantee our recovery. Our borrowing capacity remains one of our greatest assets. We should increase, not decrease, government spending to fill the demand gap. Those bond prices tell me that the markets are fine with the deficit. For now.

Which brings me to another question: are we spending our money wisely?

Not at all.

We are pouring it down the sink holes of two needless wars rather than into programs that have strong stimulative effects. Defense – offense? -spending has nowhere near the impact that increasing unemployment payments does. Neither come close to grand government works programs. This is the proper criticism to level at the anemic stimulus program of last year. And yes, it was anemic in the context of our problem.

Politics prevents us from solving the problem: we have to water down all our programs in order to reach ‘compromise’. We cannot get enough votes to extend unemployment relief even though the cost of so doing is but a week or two of our war expenditure. We have to include specious tax cuts even though all the evidence – and there is tons of it – tells us that tax cuts are just not stimulative.

Which brings me to the real reason to be worried:

Lack of leadership.

From the White House, to the opposition, to business, to academia, to ourselves. No one is willing to think on the scale that the crisis deserves. No one is willing to stand firm against the pull of the mushy center. No one wants to take responsibility and eliminate the fear that pervades the economy. Everyone, it seems, is afraid.

And that simply begets more fear.

And it leads us into wrongheaded policy making, like austerity at a time of slack demand.

That’s why I am worried. You should be too.