Moving Right Along. Sideways.

Lest you think we are now into clear water, let me remind you that the economy stinks. That’s technical economics speak for rotten, as in really bad. Nothing in the great debt ceiling debacle changes anything. While we were all distracted by the farce that is American politics, the economy slid slowly towards the precipice. To put things in perspective: the shortfall between the current pace of growth and our historic trend means we will lose about $350 billion this year. That’s a lot of idle resources sitting about doing nothing. And, since no one is doing anything to fix this malaise, we can safely project that over the next ten years – the horizon of the debt ceiling deal – the accumulated shortfall in our wealth will be between $2 and $3 trillion, or just about the same as the spending cuts. In other words it is highly likely that we will be living through a highly constrained period of constant argument over how to deal with our deficit. Each successive wave of cuts will merely press us down a little more and make reaching escape velocity that much more difficult.

To put it bluntly: we are digging the hole deeper, not filling it in.

The net effect of this debt deal may turn out to be a fat zero. Revenues will be constrained by the weak economy, as well as the constant attack from the far right, while spending will not fall as people expect because our safety net expenses will remain elevated due to the failure to get growth going.

So all in all, it is quite possible that the entire sorry episode was a total waste of time.

Apparently our elite leadership has forgotten that there are two parts to the debt percentage equation and that the second, currently overlooked half, is languishing like a lead weight around all those good, and no-so-good, intentions we just argued breathlessly about. We call this second half growth.

Without restoring annual GDP growth to something like its normal trajectory all our efforts to rein in government debt will be for naught. This is especially true in the short term as the increase in the debt ceiling could well be exhausted by this time next year if growth doesn’t perk up soon. Since I see no such acceleration on the horizon, and since policy makers seem to have forgotten that they could do something to help us all, the odds are heavily stacked towards our having a repeat of the debacle right around election time 2012.

This is an extraordinary situation to find ourselves in, but it is a direct result of our inept economic policy making. No one wants to admit the true depth of the crisis because it implies massive restorative effort at a time when the far right has successfully hobbled the application of such an effort.

For those of you who like to think of economics as somehow scientific now is a good time to break out the popcorn and watch. We are running an experiment for you. The austerity programs now being brushed up for use will cut government down in size. According to the orthodox amongst us this will unleash market magic and more than offset the reduction in government spending. Far from falling, demand will thus increase according to this theory. Let’s see. And let’s also see how long it takes for orthodox theorists to point out all the caveats and loopholes that they will need to insulate their theory from failure. Because fail it will.

As for you Austrian School types, no doubt you are looking forward with glee to the imminent burst of entrepreneurial activity now that the dead hand of government has been lifted somewhat. Good luck with that too.

For those of us with a more realistic bent the outlook is grim. The loss of demand caused by the cuts in spending will not have much impact until 2013, but do any of us truly believe that the economy will be skipping along by then and so able to absorb that loss? As I have said, I certainly do not. And, nor apparently, does big business.

The enormous shift into deeper red ink in the public sector has been associated by an almost equal shift into ever blacker ink in the private sector. This shift has benefitted corporate profits more than anything else. It is, perhaps, one of the more perverse aspects of the crisis that profits have not just held up, but boomed. This even while households wilted. This surge in profits has come largely from productivity gains as business slashed costs and more than compensated for the drop in demand. The consequence is that business is now sitting on an unprecedented amount of cash awaiting deployment. That cash is idle currently thus adding to our continued shortfall in GDP growth. Rather than invest, business is sitting on the sidelines.

The orthodox explanation for this idleness on the part of business is that uncertainty with respect to future taxation is sapping confidence. The additional argument that government borrowing is “crowding out” private borrowing is plainly nonsense: with so much cash, demand for credit in the private sector is a bit thin right at the moment. Now that the dust is clearing about government plans for the next decade, orthodoxy predicts a surge in investment is about to take place.

I don’t think so.

Without a solid level of demand growth there is no compelling need to invest. Since we are not willing to deploy government funds to get demand growing, business is looking at flatlining sales projections. The constraint in government is supposed to stimulate investment despite the lack of sales. After all in classical theory investment begets demand not the other way around. In a period of flat demand the best way to keep profits rising is to cut costs and thus boost productivity. But that will depress demand even more. So it looks like we will be cutting our way towards oblivion.

This is called getting your knickers in a twist, which is not a comfortable feeling at the best of times, and at present is downright nasty. It is the consequence of bad policy. A bad policy that we are now committed too even more strongly.

One last point to mention: if, and when, business starts to invest the way orthodox theory predicts it will, profits will inevitably decline. This is the necessary offset to government deficit reduction – if public sector red ink diminishes, so must private sector black ink, trade being equal. This implies that current stock prices may be overstating future earnings. To keep price/earnings ratios constant that suggests a drop in price. So a rise in demand will be associated with a decline, temporarily, in stock prices.

Not that you need to worry too much about that. Demand isn’t going anywhere just yet.

The drift continues.