Debt Conundrum

What I am about to say is not novel, but nor is it trite: if the austerians – the word we now use to describe those who advocate cutting public spending and debt – really believe that a reduction in public spending can spur, without doubt, economic growth, then the gap opened up by that reduction must be more than filled by something else.

So what is that something else?

Well, a sudden shift in trade could do the trick. That means a sudden expansion of US exports so that the US trade balance zooms from a sea of red ink towards being securely in the black. Canada managed this solution when it had budgetary difficulties. As did Sweden. Somehow I see this as unlikely here. Our appetite for oil sets a fairly high threshold for us to jump over, and the dollar would need to drop some more. With world oil prices moving higher, and not lower, the degree of difficulty is increased. At least near term.

And where would these exports go?

The data suggests there are only three viable trade partners to absorb enough US goods: Europe, Japan, and China. The Euro zone as we know is not in too good a shape, and has already reduced its trade imbalance with the US. The other two are more problematic. Japan is in all sorts of difficulties as result of the recent disaster, its economy is weakened in the short term, and any recovery there may not support a boom in US trade. That leaves China which continues to resist strong currency adjustment and thus blunts the possibility of a US trade surge.

So, even though the world economy is growing at a decent clip, it is not at all clear US exports are about to take off sufficiently to plug the gap opened up by reduced government spending.

So that throws the spotlight onto the private sector.

There we have two possibilities: investment and consumption.

I have berated big business enough times for you all to realize that I am highly skeptical about the probability of investment suddenly rising to the task of leading an economic charge. Business is awash with cash; profits are at very high levels – last year’s profit growth was the best since 1950 – and still investment is more of a dribble than anything else. Indeed the latest numbers suggest companies have reached a plateau in most forms of investment, and are now sitting around waiting to see if demand picks up enough to justify a second installment. The recent durable goods data shows a definite flattening out of growth in investment. There doesn’t seem to much else on the horizon.

So despite all that idle cash waiting to be deployed into productive activity, business investment is much too slow to offset the imminent reduction in the economy planned by the austerians. Every day that pile of cash goes unused the more the opportunity lost costs money. Since I don’t believe business willingly leaves profits on the table uncontested, there must be something preventing action. Clearly the business world is nervous about something.

And that something is the shape of household demand.

Which gets us to the center of our dilemma.

The current outlook for households is not exactly rosy. Wages are flat, indeed when the impact of inflation is accounted for they are going in the wrong direction. The job market still casts a pall across the economy, and causes enough anxiety to restrict much free spending. Home prices have dropped and caused a perceived need to replace that loss on household balance sheets with other assets. That means savings need to rise at least temporarily. That implies a decline, or at least a flattening out, of consumption. So little growth is likely from this quarter.

We have reached an impasse: none of the potential sources of replacement activity seem likely to play that role. Thus, a decline in public spending inevitably will lead to a smaller economy. GDP will decline from its current path. Whether that decline will be large enough to push us into recession I doubt. But it will be enough to throw us into a potentially endless sideways movement with constant high unemployment, and ugly performance in most important categories of activity. Stagnation beckons.

Unless.

Unless we go through a great boom in private debt.

Yes. That’s right. The only way the austerian project is viable is if household debt levels grow sufficiently to provide the spending power needed to offset the lost government spending.

This is truly perverse.

After berating us all for reckless borrowing and the damage it did to our economic stability, the austerity police are now relying on us plunging more deeply into debt so that they can cut public debt without cutting the economy. They just don’t want to admit it. Their entire plan relies on pumping private debt up beyond where it is currently. This does not mean that those folks who went into debt too deeply before have to return there. It means that others, people with healthy balance sheets, people who don’t normally borrow, and people who have cash anyway, all have to fill the void. As the crisis abates and the cleaning up of the bad debts accumulated back in the bubble are worked off, the austerians assume there is a pool of new borrowers waiting to jump in and provide the boost we need.

Some of this borrowing could come, I suppose, from businesses tapping into the banks and credit markets. But, as I said, business is awash with cash. Business doesn’t need to borrow. Besides they don’t seem keen to spend.

No. This increase in debt has to come from households. Especially those who sat out the last boom in debt.

Is this likely?

You answer that one.

I don’t think it is.

That means the austerity programs being shoved into place can have only one impact: they will contract the economy. Demand will fall. It isn’t too large a government budget that scares business into hoarding its cash. It is too small a government. Every dollar cut from government spending is a dollar less flowing through the pockets of business, both large and small. That means fewer jobs, not just because we fired a bunch of teachers or firefighters, but because we drained demand from the private sector and thus reduced the need to hire workers.

Expectations play a key role in the economy. As long as the austerians scream panic and cut, those expectations will tend towards being negative. This is the exact opposite of what the orthodox economists would preach. But they’re wrong anyway.

We have a debt conundrum: the fiscal conservatives are advocating fiscal recklessness. They just don’t want to say so. Then again, these are the same folks who brought us the Reagan and Bush deficits. So we should not be surprised. Not surprised at all.