Saturday, May 29, 2010

Deficit Dementia

Across the industrialized world, governments have responded to the economic crisis by running enormous fiscal deficits, rediscovering a deep, previously unacknowledged love for the legacy of John Maynard Keynes. Now there seems to be a gathering consensus that these deficits are unsustainable and have to be cut as quickly as possible. This seems to be the word from the Group of 30, the OECD, the EU, Obama’s deficit commission and the US Congress.

Genuine Keynesians have to be worried. If so many governments simultaneously decide to withdraw stimulus, the combined effect could well be to tip the world into a second round of economic tailspin. Just for starters, assume a multiplier of one; then the average reduction in fiscal deficits as a percentage of combined GDP has to be deducted from projected growth rates. Given plausible numbers on both sides, the result could well be negative. A multiplier greater than one, particularly in light of trade spillover effects, pushes us further into the red.

But the economic myopia is, if anything, even more fundamental. The deficit hawks seem to have forgotten, if they ever learned, the granddaddy of all accounting identities: a country’s current account is equal to the sum of its domestic budget positions. If you hold the CA constant, a reduced fiscal deficit is feasible only if it is offset by a corresponding increase in the indebtedness of households and firms. Of course, it was the inability of the private sector to sustain its borrowing that led to the crisis, and the runup in fiscal red ink, in the first place.

Notice that the biggest pressure to cut government spending is being felt in the countries running current account deficits, like the US, the UK and the peripheral members of the eurozone. This is not surprising, since, according to the laws of arithmetic, they must also have the biggest domestic budget deficits. If squeezing the public sector could produce expenditure-switching, so that countries on a fiscal diet would also find their way to external balance without economic collapse, that would be the proper medicine. Unfortunately, there is no evident channel by which this can happen. The US and the UK are unlikely to see a substantial devaluation as a result of their fiscal rectitude, and the folks in the eurozone can’t devalue at all. If there is to be rebalancing as a result of these cuts, it will happen only through shrinkage of incomes and employment.

So that’s what the arithmetic tells us: fiscal cuts must equal the sum of increased private indebtedness plus decreased external deficits, where the latter are driven by economic contraction. Lovers of historical irony will note that this is exactly the circumstance Keynes was responding to in the 1930s, informed by his prior analysis of the imbalance-generating Treaty of Versailles. His insistence on the need for symmetry in adjustment was directed against the foolhardy insistence that deficit countries must shrink and shrink, dragging down the surplus countries as well.


Jazzbumpa said...

In other words, we know perfectly well how to prevent a world-wide depression, but because of a deficit dementia mindset, we (here, Britain, the Eirozone) refuse to do it, and we're all screwed.

Sounds about right.

Lo siento,

TheTrucker said...

Why do these people imagine that we are still on the gold standard? Why is it not recognized that the value of a currency is based on the level of government spending versus the level of taxation? And assuming that this is recognized then why is it that the holders of money are to be protected at the expense of the productive people in the society?

Keynes had to deal with the gold standard. We don't.

But the dollar cannot be the world's "reserve currency" and at the same time "float" so as to balance trade. The Euro is being devalued to deal with the Greek mess. That leaves the middle class of the USA being the whipping boy for the rich. This is not right.

Min said...

The Trucker: "why is it that the holders of money are to be protected at the expense of the productive people in the society?"

How do you produce a servant class?

Eubulides said...

How many rotten economists in a barrel before we declare the barrel itself is rotten and the water irreversibly toxic?

Time to start decredentializing the staffs of the institutions mentioned in the post; alas there seems to be no internationally recognized body authorized to do so.....

Perhaps James Lovelock is right; the human race is too incompetent to be long term member of adaptive strategizing on the evolutionary stage.

BenL8 said...

At they quote Edward Wolff's analysis of wealth distribution in the U.S. that shows that the top one percent of households held 44% of wealth in 1929, but dropped to 27% in 1949. I attribute this shift to full-employment policies from 1938 to 1946, when essentially idle wealth poured into government bonds and then into workers' paychecks - a transfer of wealth, and a huge internal debt of 120% of GDP. Creating high deficits transfers wealth, decreases the long-term stability of financial assets, but if invested wisely also in turn creates wide-spread demand to propel growth and internal improvements of health, education, housing, etc.. The now discredited economists and financial wizards and their wealthy backers wish to stop the hemorrhaging financial asset values by scaling down fiscal stimulus. Wolff recently showed (see Levy Institute report) that 2007-2009 the top one percent lost 17% of value while the median household lost 36% of value, pushing the median household wealth down to the 1983 level of $65,450 ( has an excellent article about this at the top of it's page). Robert Dorman's plan for the banks, Plan B, published in late 2008 was right on. So is this article. My blog is for an essay about full employment. There will either be economic justice and democracy or a global slave class with a global financial hegemonic class.

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