Policy Research in Macroeconomics

Obama (and Congress) can’t cut the budget deficit

By Ann Pettifor

The terrific hoo-ha around the US Budget Deficit is just that: hot air – predicated on the fallacy that President Obama and an ideologically-driven Republican Congress can cut the deficit.

They can’t.

It’s a delusion that arises because economists insist on applying microeconomic reasoning to macroeconomic conditions. It’s a delusion that leads to broader misunderstanding as voters wrongly make the link between their own individual budgets and the government’s budget.

It’s an error because economists (like Christine Romer in ‘Lessons from the New Deal’ 2009) confuse and merge outcomes (the budget deficit) with the fiscal stance of government (increased or lower spending).

It’s a mistake because while you and I can cut our budget deficit by reining in our spending and generating new income – the US government can’t.

That’s because the government can only cut spending – but can’t cut the deficit. The size of the deficit is an outcome – and depends on the reaction of the whole economy to cuts in government spending.

Since government can’t control the deficit, trying to reduce the deficit is like looking through a telescope the wrong way around….

If cuts in government spending lead to job losses in the private sector, and rises in welfare payments – cuts will not lead to a fall in the deficit. Instead they will increase the budget deficit – as tax revenues from both the public and private sectors fall and welfare payments rise.

If at a time of spare capacity and a collapse in private sector economic activity, government spending rises, leading to growth in activity and employment, then the deficit will fall.

However, if at a time of high unemployment, government spending rises only fitfully, as it did after the US’s 2009 Recovery Act, there should be little change – in either employment or public finances.

And so it has proved. The Congressional Budget Office tells us that the budget deficit of $1.3 trillion in 2010 was lower than that in 2009, falling from 10% of the nation’s output to 8.9% in 2010. The small fall confirms that stimulus works to reduce the deficit. It also confirms the slow and inadequate nature of the Obama stimulus; one that was not ‘shovel ready’ and did not inject sufficient investment in infrastructure and jobs.

So let’s jinx the phoney debate between those who want to cut the deficit, and those (supposedly Democrats and other Lefties) that don’t.

Let’s accept the consensus: everyone, from the IMF down, wants to cut the deficit.

The debate then becomes more rational: does lower government spending cut the deficit? Or at times of financial and economic failure, foreclosures, bankruptcies and high unemployment – does increased government spending cut the deficit?

I am betting that Republican-driven ambitions for lower government spending would increase the deficit, if they were ever to reach the statute book. It’s counter-intuitive I know, but then that’s macroeconomics.

The reason I am so confident is that Prof. Victoria Chick and I have examined a century of British government spending. In our paper “The Economic Consequences of Mr Osborne” we explore the impact on public debt of cuts (fiscal consolidation) and increases (stimulus) in government spending .

We find that over the last 100 years, stimulus has in most cases cut levels of public debt as a share of GDP, and fiscal consolidation has increased the debt.

Perhaps most remarkable is our finding that Britain embarked on a war in 1939 when public debt stood at about 150% of GDP; that nevertheless the war was financed and Hitler defeated. At the end of the war, government debt had hit 250% of GDP, at which point the Labour government began to spend: on the National Health Service, public education and public housing. The public debt fell systematically as a share of GDP until it reached 20% or so, where it remained for about 50 years – until the latest, and unnecessary, financial ruin inflicted on the UK economy.

Similarly, the United States’ debt amounted to about 60% of GDP at the end of the financial crisis of the 1930s, at which point the US government successfully financed its intervention in World War II. At the end of the war, US debt stood at about 120% of GDP. The nation then entered the ‘Golden Age’ of economic recovery and stability. Directly as a result, public debt fell steadily until the financial de-regulation and fiscal laxity of the Nixon/Reagan years.

According to the Congressional Budget Office, US government debt was only 36% of GDP at the end of fiscal year 2007, just before the US economy was ruined by the reckless activities of Wall St. Today, and as a direct result of economic failure, the debt stands at 62% of GDP.

The gravest threat facing the US now is not war: it’s economic failure, unemployment and climate change, leading to job insecurity, energy insecurity and food insecurity.

To tackle these insecurities, the US will have to do what was done in the 1930s: restrain the finance sector, and subordinate it to the role of Servant to the economy.

In that role, Finance should work with Congress to fund the necessary job creation and infrastructure necessary to restore economic, energy and food security to the people of the United States.

Fortunately this mission will coincide with our shared goal: to reduce the budget deficit. For the simple fact is this: the public finances will not recover, until the economy recovers. Or as Keynes argued: “look after unemployment and the budget will look after itself.”

This post originally appeared on the Triple Crisis Blog >

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