Marshall Auerback warns Obama, You can't cut deficits by cutting spending

We half-disagree with Marshall Auerback here, as we half-disagree with most progressive economists. Deficits do not necessarily mean stimulus. As we argued on Tuesday's podcast, deficits can be reduced by enlightened revenue measures. Auerback is right here, however, to stress that reducing aggregate demand by reducing spending as a way out of deficits is not going to work.

President Obama, deficit terrorism is not the answer!
by Marshall Auerback
from New Deal 2.0
November 15, 2009

Oh dear, there he goes again.

After sensibly calling for a jobs summit to deal with the problem of rising unemployment, President Obama’s Herbert Hoover-like alter ego has re-emerged again to warn us again about the evils of government deficit spending. According to Politico.com, the President “plans to announce in next year’s State of the Union address that he wants to focus extensively on cutting the federal deficit in 2010 — and will downplay other new domestic spending beyond jobs programs, according to top aides involved in the planning.”

The President and his economic advisors are now being driven by the polls, which, in turn, are being driven by the deficit myths of their own creation. It is a case of the blind leading the blind down the rabbit hole. They impose political constraints on their own actions in a manner which is highly destructive in terms of securing their prized legislative goals (like the health care debate, where all decent policy proposals have foundered on the question of “how are we going to make this ‘deficit neutral’”?).

The Administration fails to understand that the “solution” of cutting back government spending is not a solution at all. It won’t actually achieve the “desired” result because the destruction of tax revenue through a declining economy — caused by the cutbacks in spending — will run counter to the President’s stated (and misguided) goal. There are two ways to obtain large budget deficits: the “ugly” way and the “virtuous” way. Like Japan during it’s “lost decade,” we have mostly gotten the deficits the bad way–by destruction of tax revenue caused by a collapsing private sector. Early fiscal measures have done enough to stabilize aggregate demand, but done little to generate sustained recovery.  So they get discredited and public debt trap questions keep getting raised, which in turn inhibits a fiscal response properly sized and held. The economy waffles through stagnation.

Now, I realize that some of the economic moralists amongst us think that cutting back government spending is a wonderful thing because we will “purge” the system of its “socialistic” tendencies (see Governor Rick Perry of Texas) and end “malinvestment.”  But that’s an interesting social experiment I hope the President is not prepared to undertake.

At the core, we have a problem of insufficient aggregate demand. The government is the only entity in a position to remedy that problem, because only the government can create new net financial assets via spending. There are any number of measures which would have an almost instantaneous impact in terms of improving aggregate incomes and demand. A national payroll tax holiday, revenue sharing with the states (so as to preclude additional cuts in state spending which offset the Federal fiscal stimulus) and a government as employer of last resort (an idea we plan to expand on further in a subsequent New Deal 2.0 posting) would all do the trick.

In the 1930s, we had a president who was unafraid to embrace bold experimentation. He wasn’t always right, but by the end of 1934, more than 20 million Americans (one out of six) were receiving jobs or public assistance of one form or another from the “Welfare State”. The system remained viable thanks to FDR. As I’ve written elsewhere, the government hired unemployed Americans to work on projects that advanced our society during the Great Depression:

“The government hired about 60 per cent of the unemployed in public works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America, and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much of the Chicago lakefront, New York’s Lincoln Tunnel and Triborough Bridge complex, the Tennessee Valley Authority and the aircraft carriers Enterprise and Yorktown.
It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields. And it employed 50,000 teachers, rebuilt the country’s entire rural school system, and hired 3,000 writers, musicians, sculptors and painters, including Willem de Kooning and Jackson Pollock.”

On housing (a huge contributor to the current crisis), both L. Randall Wray and Eric Tymoigne have argued,

“A more effective way to restart the economic process on the solid ground is to deal with the underlying cause of the problem: borrowers cannot meet the required payments. This implies sustaining their income and employment and, if necessary, drastically modifying their debt service burden. The whole boom of the 2000s (and more broadly the growth process that emerged at the in the early 1980s) was based on household borrowing and the continuation of negative saving trends (that is, household deficit spending).”

One good place to start would be loan modifications, which would have a much more beneficial impact than what we’re doing now. Today, when the homeowner stops making payments, the mortgage company that services the loan makes the payments that are then distributed to the securities holders, so the economic incentives actually discourage active loan modification and worsen the home owner’s personal balance sheet. It is in the interest of the mortgage companies that service mortgages to maximize the number of delinquencies as well as the amount of time each household is delinquent.

A vastly superior alternative would be a Home Owners’ Loan Corporation (HOLC) type of entity, advocated as early as January 2008 by Paul Davidson:

“In 1933, the Home Owners Refinancing Act created the Home Owners’ Loan Corporation (HOLC) to refinance homes to prevent foreclosures, and also to bail out mortgage holding banks. The HOLC was a tremendous success, making one million low-interest loans which often extended the pay-off period of the original loan, thereby significantly reducing the monthly payments to amounts that homeowners could afford. In its years of operation, the HOLC not only paid all its bills, but it also made a small profit.”

To be sure, any program designed to increase incomes and aggregate demand will certainly require a major increase in government spending, precisely the opposite of what Obama is calling for right now. Even a focus on the “jobs deficit” is misguided because the President fails to understand that it is the overall growth in government spending which will facilitate private sector deleveraging, not the selective application of government. But if the President is genuinely concerned about spending too much money, he can simply redeploy part of the $23.7 trillion committed to help the banks to finance the programs above.

In any event, the President’s single-minded focus on the budget deficit is profoundly misguided. Why? Because a sovereign government can always afford to buy anything that is for sale in its own currency –whether that is unemployed labor, real estate, or bad financial assets. This focus on “affordability” and “fiscal sustainability” is ridiculous: these are empty phrases which mean nothing when divorced from the economic backdrop. The size of the deficit is irrelevant in itself. There is no meaning in the terms a large deficit or a small deficit. You have to relate them to the extent of labor and capital underutilization, which is a human measure of the aggregate demand deficiency. The fact that labor underutilization is now in excess of 17.5 per cent in the US (combined unemployment, underemployment and hidden unemployment) and capacity utilization is in the 60-65 per cent range rather than 90 per cent range sends one very clear message - the deficit is not large enough.

In a year Obama has gone from “we cannot afford not to do this” to “we’ve run out of money”.

If we continue down this path, such that robust recovery does not begin for many years, we will have large budget deficits for many years to come. Of course, it could always get worse –if Obama is serious about his singular focus on the deficit, which I fear he is.