By Marshall Auerback, a fund manager and investment strategist who writes for New Deal 2.0.
A recent poll by Douglas Schoen and Patrick Caddell suggests that swing voters in the US, who are key to the fate of the Democratic Party, care most about three things: reigniting the economy, reducing the deficit and creating jobs.
But the latter two goals are generally incompatible, especially during major recessions.
In times of high unemployment, government deficits are required to underwrite growth, given that the private sector shift to non-government surpluses has left a huge spending gap and firms responded to the failing sales by cutting back production. Employment falls and unemployment rises. Then investment growth declines because the pessimism spreads. Before too long you have a recession. Without any discretionary change in fiscal policy (now referred to in the public media as "stimulus packages") the government balance will head towards and typically into deficit, unless the US miraculously becomes an export powerhouse along emerging Asia lines, and runs persistent current account surpluses, to a degree which allows the governments to run budget surpluses.
This is not going to happen, particularly when the largest current account surplus nations, notably Germany, cling to a mercantilist export led growth model, an inevitable consequence of that country's aversion to increased government deficit spending. The German government's reticence to counter any kind of shift in regard to its current account surplus is particularly significant in light of the ongoing and intensifying strains developing in the EMU nations (see here) . Last week's Greek "rescue" is Europe's "Bear Stearns event". The Lehman moment has yet to come. One possible outcome of this could well be significantly larger budget deficits in the US and a substantial increase in America's external deficit, given the unlikelihood of America becoming an export super power again. Let me elaborate below.
In the euro zone, I now see one of two possible outcomes. Scenario 1: the problem of Greece is not contained, and the contagion effect extends to the other "PIIGS" countries, leading to a cascade of defaults and corresponding devaluations as countries exit the EMU. Interestingly enough, the country which could well be affected most adversely in this situation is France, as the country's industrial base competes largely against countries like Italy and the corresponding competitive devaluation of the Italian currency in the event of a euro zone break-up could well destroy the French economy (by contrast, as a capital goods exporter with few euro zone competitors, Germany's industrial base will be less adversely affected in our view).
In Scenario 2 (more likely in my opinion) we get some greater fears about other PIIGS nations (discussion is now turning to Spain, Portugal and Ireland). The EMU might well hold together but the corresponding fear of contagion might well provoke capital flight and drive the euro down to parity (or lower) with the dollar. Of course, the euro's weakness creates other problems: when the euro was strengthening last year due to portfolio shifts out of the dollar, many of those buyers of euro bought euro denominated national government paper (including Greece). The resultant portfolio shifts helped fund the national EMU governments at lower rates during that period. That portfolio shifting has largely come to an end, making national government funding within the euro zone more problematic, as the Greek situation now illustrates.
The weakening euro and rising oil prices raises the risk of "?inflation' flooding in through the import and export channels. With a weak economy and national government credit worthiness particularly sensitive to rising interest rates, the European Central Bank (ECB) may find itself in a bind, as it will tend to favor rate hikes as prices firm, yet recognize rate hikes could cause a financial collapse. And should a government like Greece be allowed to default, the next realization could be that Greek depositors will take losses, and, therefore, the entire euro deposit insurance lose credibility, causing depositors to take their funds elsewhere.
It all could get very ugly for the ECB. The only scenario that theoretically helps the value of the euro is a national government default, which does eliminate the euro denominated financial assets of that nation, but of course can trigger a euro wide deflationary debt collapse. The 'support' scenarios all weaken the euro as they support the expansion of euro denominated financial assets, to the point of triggering the inflationary "?race to the bottom' of accelerating debt expansion.
So timing is very problematic. A rapid decline of the euro would facilitate a competitive advantage in the euro zone's external sector, but it could also set alarm bells off at the ECB if such a rapid devaluation creates perceived incipient inflationary strains within the euro zone.
What about the US? In the latter scenario, we can envisage a situation in which the combination of panic and corresponding flight to safety to the dollar and US Treasuries, concomitant with the increased accumulation of US financial assets (which arises as the inevitable accounting correlative of increased Euro zone exports) means that America's external deficits inexorably increase. There will almost certainly be increased protectionist strains, a possible backlash against both Europe and Asia, especially if the deficit hawks begin sounding the alarm on the inexorable rise of the US government deficit (which will almost certainly rise in the scenario we have sketched out).
Assuming that the US does not wish to sustain further job losses, the budget deficit will inevitably deteriorate further, either "virtuously" (via proactive government spending which promotes a full employment policy), or in a bad way , whereby a contracting economy and rising unemployment, produce larger deficits via the automatic stabilisers moving to shore up demand as the economy falters. How big can these deficits go? Easily to around 10-12% of GDP or higher (versus the current 8% of GDP) should a euro devaluation be of a sufficient magnitude to induce a sharp deterioration of America's trade deficit. Possibly even higher.
What will be the response of the Obama Administration? America can sustain economic growth with a private domestic surplus and government surplus if the external surplus is large enough. So a growth strategy can still be consistent with a public surplus. But this becomes virtually impossible if the euro zone's problems continue, as we suspect that they will.
President Obama, however, has long decried our "out of control" government spending. He clearly gets this nonsense from the manic deficit terrorists who do not understand these accounting relationships that we've sketched out. As a result he continues to advocate that the government leads the charge by introducing austerity packages – just when the state of private demand is still stagnant or fragile. By perpetuating these myths, then, the President himself becomes part of the problem. He should be using his position of influence, and his considerable powers of oratory, to change public perceptions and explain why these deficits are not only necessary, but highly desirable in terms of sustaining a full employment economy.
Governments that issue debt in their own currency and do not promise to convert their currency into anything else can always "afford" to run deficits. Indeed, in this context government spending financially helps the private sector by injecting cash flows, providing liquid assets and raising the net worth of some or all private economic agents. In contrast to today's budget deficit "Chicken Littles", we maintain that speaking of government budget deficits as far as the eye can see is ludicrous for the simple reason that as the economy recovers, tax revenue rises, the deficit automatically reduces. That's the whole reason for engaging in deficit spending in the first place. Any projections that show the deficit continuing to climb without limit is misguided "” the Pete Peterson projections, for example, will never come to pass. As we near and exceed full employment, inflation will pick-up, which reduces transfer payments and increases tax revenues, automatically pushing the budget toward surpluses.
In the 220 year experience of the United States there have only been a few years when we've not had deficits and each time the surpluses were immediately followed by a depression or a recession. History shows that we can run nearly permanent deficits and that when we do, it's better for the economy. The challenge for our side of the debate is to expose these voluntary constraints for what they are and explain why the US is not a Weimar Germany waiting to happen.
And here I thought we’d all agreed on “Deficit Errorist” as the accepted pejorative term for Keynesians to use, as some of us — especially ones professionally engaged in identifying & defeating real-world violent terrorists — take umbrage at being labeled “terrorist” for our principled, non-violent stance that deficits are to be avoided, even at the cost of a deflationary spiral, higher unemployment, and increased social anxiety/pain.
We deficit-hawks don’t wish the economic pain evident in deflationary spirals on anyone … but we recognize the wound is already inflicted, it’s now just a matter of how the pain gets spread around. Besides, if gov’t shields people from painful natural consequences they’ll never reform their, or their gov’t, behavior.
“even at the cost of a deflationary spiral, higher unemployment, and increased social anxiety/pain.”
Pretty much sounds like terrorism to me, particularly if there’s no real cost to doing the opposite.
Read that 2nd paragraph again, boot boy. The damage already exists.
All talk of ‘controlling the deficit’ is hogwash, as is all talk of the Fed’s ‘exit strategy’. Yes, the Euro is on its way to $.85, but it has been $.85 before and the world didn’t end. Why is it that nothwithstanding universal fiat money, so called authorities keep blathering about the ’sustainability of deficits’?. Perhaps for the same reason these same authorities insist it is impossible to tax the rich or the corporations? What we face is a political problem, not an economic problem. If every banker were stripped naked and floated out to sea the only consequence would be a reduction of leverage.
I don’t know Marshall. Seems to me that Europe with even more massive deficits is in a bad situation. Our repayment on the national debt is something I wish you would look into. I think it will be enormous. And bubbles aren’t held in check when we have this spending and inflation. Look how much gasoline has gone up.
Vespasian,
In deference to your delicate sensibilities, I promise not to use the term, “deficit terrorist” again. I do not wish to imply that “deficit hawks” (let’s use your term for the sake of comity) wish to inflict pain on everybody. I’m simply extending the logic of a financial balances approach. We hear politicians and the media arguing that the current federal budget deficit is unsustainable. I have heard numerous politicians refer to their own household situation: if my household continually spent more than its income year after year, it would go bankrupt. Hence, the federal government is on a path to insolvency, and by implication, the budget deficit is bankrupting the nation. That is a fallacy of composition. It ignores the impact that the budget deficit has on other sectors of the economy. How does this work in practice? If households attempt to net save by spending less than they are earning, and businesses attempt to net save (reinvesting less than their retained earnings), then nominal incomes and real output are likely to fall. Money incomes and economic activity will tend to contract until private savings preferences are reduced (with essential goods and services taking up a larger share of household income as incomes fall), or until depreciation leaves businesses and households inclined to invest once again in durable assets. Common sense suggests that a drop in private income flows while private debt loads are high is an invitation to debt defaults and widespread insolvencies "“ that is, unless creditors are generously willing to renegotiate existing debt contracts en masse. Which is why any particular nation in these circumstances must either run an external surplus on its current account, or experience a rising government deficit or some combination of the two. Of course, given the prevailing levels of government deficit hysteria in the US right now, one can see the political appeal of focusing on export led growth, along Asian lines, since a sufficiently large trade surplus will facilitate the government's ability to cut spending and run public sector surpluses. The problem of course comes from the fact that it is impossible for all governments (in all nations) to run public surpluses without impairing growth because not all nations can run external surpluses. There has to be another nation willing to become a net importer. For nations running external deficits (the majority), public surpluses have to be associated with private domestic deficits, which is inherently constraining in a way that government deficits are not. Historically the US private sector has spent less than its income"”that is, it has run a surplus, whereas the government has run deficits. From a straight national accounts identity, then, the paradox of private sector thrift is that it is facilitated by public sector profligacy. Or another way of putting it: every time the government runs a deficit and issues a bond, adding to the financial wealth of the private sector. Of course, the opposite would also be true. Assume we have a balanced foreign sector and that the government runs a surplus"”meaning its tax revenues are greater than government spending. By identity this means the private sector is spending more than its income, in other words, it is deficit spending. The deficit spending means it is going into debt, and at the aggregate level it is reducing its net financial wealth. By extension, a country which runs a large trade deficit (as the US has persistently done for the past quarter century), needs an even greater degree of government fiscal expenditure to offset the potential "deficit" spending by the private sector. Unless you think the US is going to become an export superpower, what you’re telling me is that the elimination of government deficits is more important than the elimination of unemployment. That’s a political position. But how do you get there, given the fact that the deficits are largely endogenously determined? I’m really asking you to sketch out the logic of your position, as I’m making an operational point about government spending, not an ideological one.
Its hard to argue with idiot savant academics and other clueless politicians. All you have to do is read Cicero to learn about war and debt. The modern world is losing wisdom and no one understands that knowledge is subtractive. We know from history what not do.
Excuse me if this is not an exact figure, but the projected deficit for the current fiscal year is what? $1.6 Trillion? Back of the napkin calculation: 12% of GDP? Wow, that’s real austerity. That’s Grecian austerity. Projected $1 Trillion deficits as far as the eye can see, assuming a return to normal growth rates. Where is this Obama austerity of which you speak, Mr. Auerback? Mr. Obama occasionally mouths the words of austerity and deficit control, but they’re only words. He proposed controlling spending in a small slice of the government spending pie, not addressing about three quarters of the rest.
As a deficit terrorist, but one who can be reasoned with, I would like to ask if you can provide any historical examples of a nation already as deeply in debt as we are (400% of GDP) who proposed to run the kinds of deficits we are planning to run for at least a decade into the future, that has experienced any kind of a strong recovery and return to normalcy. Otherwise, you are asking us to accept government-spending-without-revenue as a remedy on faith.
“Faith is the evidence of things hoped for, the substance of things not seen.” (Hebrews 11:1) Or, as the NIV translation puts it, “Now faith is being sure of what we hope for and certain of what we do not see.”
In this matter, I would prefer to rely on history rather than hope.
Hi Marshall,I agree that the sky is not falling, but it all depends on economic growth. We were a growing society back in the 1800’s. Not sure we are today, nor that we can act the same today. What if rates go up as investors get nervous? It is happening in Greece.
Sorry, Eric, I meant that for Marshall. I always hit the wrong reply button here.
Gary, With one brief exception, the federal government has been in debt every year since 1776. In January 1835, for the first and only time in U.S. history, the public debt was retired, and a budget surplus was maintained for the next two years in order to accumulate what Treasury Secretary Levi Woodbury called “a fund to meet future deficits.” In 1837 the economy collapsed into a deep depression that drove the budget into deficit, and the federal government has been in debt ever since. Since 1776 there have been exactly seven periods of substantial budget surpluses and significant reduction of the debt. From 1817 to 1821 the national debt fell by 29 percent; from 1823 to 1836 it was eliminated (Jackson’s efforts); from 1852 to 1857 it fell by 59 percent, from 1867 to 1873 by 27 percent, from 1880 to 1893 by more than 50 percent, and from 1920 to 1930 by about a third. Of course, the last time we ran a budget surplus was during the Clinton years. Has any household been able to run budget deficits for approximately 190 out of the past 230-odd years, and to accumulate debt virtually nonstop since 1837? As discussed above, there are firms that grow their debt year-after-year so it is conceivable that one might be found with a record of "profligate" spending to match the federal government's. Still, the claim might be that firms go into debt to increase productive capacity and thus profitability, while government's spending is largely "consumption".
Fourth, the United States has also experienced six periods of depression that began in 1819, 1837, 1857, 1873, 1893, and 1929. Therefore, every significant reduction of the outstanding debt, with the exception of the Clinton surpluses, has been followed by a depression, and every depression has been preceded by significant debt reduction. The Clinton surplus was followed by the Bush recession, a speculative private-debt fueled euphoria, and then the collapse in which we now find ourselves. The jury is still out on whether we might yet suffer another great depression. While we cannot rule out coincidences, seven surpluses followed by six and a half depressions (with some possibility for making it the perfect seven) should raise some eyebrows. And, as we will show below, our less serious downturns in the postwar period have almost always been preceded by reductions of federal budget deficits.
In what way is Germany’s economic policy mercantilistic, which always implies protectionism? Having a highly competitive industrial sector that build things the world wants to buy = mercantilism?
Germany pursues full employment through exports and restraining domestic consumption. Then gets angry at other countries like Greece, etc., that must run deficits to create full employment. As Marshall explained, not every country, by definition can have current account surpluses. If Germany’s going to create its jobs by being competitive, less competitive EU countries will have to do it through building leverage in the private or govt sectors. If another country were to replicate Germany’s approach, Germany would be the one needing larger govt deficits. In other words, some country will be less competitive and will need govt deficits. It’s just accounting.
How do they “restrain private consumption”?
I don´t know of any German law that says that German households have to maintain a savings rate of 11%.
If they had followed the US and UK example consumption certainly would be higher. But would it be a good idea?
Likewise credit card debt is almost unknown in Germany. Also no housing bubble. So without a lower savings rate consumption probably won´t reach US levels.
You've answered your own question. For the record, I don't think "?restraining domestic consumption' is necessarily a bad thing. It's a choice, and it has worked well for Germany overall. But if Germany's going to be successful at it, some other country or countries must do the opposite, by definition, or else none of them will have full employment. That is, Germany needs some country to buy its exports, and the workers in that country need their own jobs to enable them to buy Germany's exports. Given a German trade surplus, the other country can't do this without either private dissaving or government deficits. It's just accounting.
Reply
Ok, a few remarks/questions.
Germany exports goods and services, which creates domestic jobs. Germany also exports capital (and quite a lot of it), which reduces domestic demand and investments, i.e. it costs jobs. By the way, Germany has not seen full employment in many decades.
It seems to me that a current deficit doesn’t have to be a problem. Countries could take German capital, use it to buy German-made capital goods and put them to productive use and thus create economic growth and jobs while running a trade deficit. It appears to me that the problem isn’t the influx of foreign capital, it’s the malinvestment of it.
Furthermore, I am still not quite sure what exactly it is that Germany is doing to “restrain domestic consumption”? What exactly are you referring to? Germany’s refusal to deficit spend like there’s no tomorrow? Is 6% of GDP not enough? How big a deficit should Germany run, in your opinion? Would another country joining the ranks of 10+% deficit spenders really be a viable long term solution?
Or maybe you’re referring to real wage stagnation? This is certainly true for Germany, as it is for the USA and many other countries. That’s the just the reality of a globalized economy, especially when Poland and the Czech Republic are your next-door neighbors and even lower wage countries are just a few miles further to the east of these.
What exactly is it that you want Germany to do? Make its industry less competitive? Ok, jobs would vanish to Eastern Europe and Asia, budget deficits would rise and then?
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