Decided to try to get a bit more publicity for Post Keynesian ideas!
Nothing I haven’t said here before. It was very lucky in that they were willing to accept a 2400-word article. Even with that, however, the issue is complex and it bothers me that I couldn’t cover everything. Having said that, the majority of questions I have received so far were already answered in the article!
Today is my 50th birthday (meaning I was born on the day JFK was inaugurated). It’s been very nice so far, with lots ad lots of kind wishes from friends and relatives, and I was really looking forward to enjoying myself today. Then I read this:
The first sentence reads, “Moving aggressively to make good on election promises to slash the federal budget, the House GOP today unveiled an eye-popping plan to eliminate $2.5 trillion in spending over the next 10 years.” Absolutely terrifying. I haven’t felt this depressed and hopeless since Sept 11.
If anything close to this really happens, we can say goodbye to economic recovery any time in the foreseeable future. I’d go into details as to why that is true, but a) that’s the subject of the previous two posts (plus several before that) and b) it’s my birthday. Suffice it to say that the people in charge in our country fundamentally misunderstand how the economy actually works. They are more interested, anyway, in name-calling and political one-upmanship.
My friend, Tschäff Reisberg, made a flash video of my blog post on the debt and the deficit and posted it to You Tube:
Thanks, Tschäff! Very nicely done!
(and why cutting spending right now would be an unmitigated disaster)
There may be no single economic concept that is more poorly understood by the lay public and most politicians (both varieties) than the federal government’s budget. I suspect that some of that is willful ignorance with an ulterior motive, but the vast majority is simply and solely because it has never been explained to them. They assume it’s like their personal or business budget. It’s not. It’s fundamentally different and lessons drawn from one cannot necessarily be applied to the other. I’ll try to make this as short as possible but, dammit, it’s sort of complicated! You can’t truly understand it, however, without this background–and you need to understand it.
UNDERLYING ECONOMIC PROBLEM
First off, you’ll need a basic understanding of the operation of the macroeconomy as a whole. Think of it this way. Say that there are eleven people in our economy playing the following roles:
1. Adam: worker
2. Betsy: worker
3. Charlie: worker
4. Danielle: worker
5. Eva: worker
6. Fred: worker
7. George: worker
8. Hannah: worker
9. Isaac: worker
10. John: worker
11. Kate: entrepreneur
There is no government and no foreign sector. Kate is the only potential employer in this world, and she has a factory that makes all the goods and services that everyone else demands. Kate’s factory can produce sufficient output for all ten workers (for simplicity I’ll ignore the fact that Kate needs to consume, too), but by employing only eight of them. Kate is not a charity–she has a family to feed, as well–so she won’t hire all ten just to be nice. She only needs Adam through Hannah to make goods and services for Adam through John, and therefore that’s all she’ll hire. But wait, that’s not quite right, is it? Because if Isaac and John don’t have job (recall that Kate is the only employer), then there is no point is making goods they can’t afford to purchase. Hence, Kate doesn’t even hire eight people. For sake of argument, let’s say that rolling back production to seven people creates an equilibrium in which Kate can hire Adam through George and they only create output for Adam through George.
Now we have the following:
1. Adam: working for Kate
2. Betsy: working for Kate
3. Charlie: working for Kate
4. Danielle: working for Kate
5. Eva: working for Kate
6. Fred: working for Kate
7. George: working for Kate
8. Hannah: unemployed
9. Isaac: unemployed
10. John: unemployed
11. Kate: earning profits associated with sales to seven workers
In the smallest nutshell possible, this is how the macroeconomy works. It is absolutely vital to understand this in thinking about the federal (though not state and local–they DO operate like your personal budget) government budgets.
Put in the front of your mind a fundamental fact about the above situation: we have the physical capacity to produce output for Hannah, Isaac, and John, but because we can do so relatively easily (i.e., without their help), they have to go without. Not only is this a really crappy deal for Hannah, Isaac, and John, but Adam through George are probably somehow supporting them (officially or unofficially) and Kate would love to be earning the extra profits associated with sales to those three. EVERYONE is made worse off by this situation. The underlying problem is that as productivity increases, so it becomes more and more difficult for the profit motive alone to generate full employment in a macroeconomy.
But note how incredibly easy this is to solve in a way that raises everyone’s welfare:
1. Adam: working for Kate
2. Betsy: working for Kate
3. Charlie: working for Kate
4. Danielle: working for Kate
5. Eva: working for Kate
6. Fred: working for Kate
7. George: working for Kate
8. Hannah: working for Kate
9. Isaac: soldier (government job)
10. John: police officer (government job)
11. Kate: earning profits associated with sales to ten workers
Let’s create a government sector and have them make Isaac a soldier and John a police officer. They are each paid a salary sufficient to buy what Kate is selling, and this leads Kate to hire Hannah (since she now needs to produce more output) and everyone is happy: Adam through George don’t have to support three unemployed people, Hannah, Isaac, and John can now share in the output that could already be produced for them, and Kate earns higher profits. In addition, not only did Adam through George have to give up absolutely nothing in terms of what they had been buying from Kate, but they how have protection from domestic and international aggression. EVERYONE is better off.
This is the essential role of the federal government in a mature capitalist economy. Without the government supplementing demand, the system breaks down and despite our ability to produce goods and services for everyone, we don’t. There will also be cyclical highs and lows (we are experiencing the latter at the moment, in case you had not noticed!), but in general we face the problems outlined above and this is something the private sector cannot solve on its own.
FINANCING GOVERNMENT SPENDING
Whence comes the money the government uses to pay Isaac and John?
Option 1: Taxes
They could tax those originally working (Adam through George), but then that means they won’t be able to buy the same volume of Kate’s products as they were before. There is no logical reason that Adam through George should have to settle for less, so that’s not a good idea. All we would be doing is changing who had the income generated in the macroeconomy (i.e., taking it from Adam through George and giving it to Isaac and John–recall that Hannah’s salary is created by private sector sales to Isaac and John). We need MORE income, not a redistribution. Again, there is zero reason why Adam through George need give anything up.
Option 2: Borrowing
The government could borrow money from those originally working (Adam through George) and use that to pay Isaac and John (Hannah gets paid from private-sector profits arising from sales of Kate’s products to Isaac and John). This assumes that Adam through George are earning enough to both buy from Kate and save some money, but if so, then this might be a useful thing to do. It would probably give Adam through George a relatively low rate of return, but a very safe investment. In fact, when they first introduced US government t-bills (during WWI), they were TOO popular!
However, our goal is not to give Adam through George an attractive means of saving, but to create jobs for Isaac and John (directly) and Hannah (indirectly). In addition, there is absolutely no reason to expect that the volume the government could borrow would equal what they need to pay the salaries of Isaac and John. It depends entirely on how much savings currently exist. Furthermore, people are least likely to be willing to tie up savings in such instruments precisely when we would be most in need of selling them: during recessions. And they would have less income to save, too. Furthermore, we don’t want people to become fixated on the idea that if the government borrowed, this means they have to pay it all back. Of course, each individual debt must be honored, but a) it need never be reduced to zero and b) so long as the debt is owed in dollars (as it is) then we can never go bankrupt. In fact, one of my colleagues actually has a page where he has promised $100 million to pay down the debt if anyone can prove that the US can go bankrupt:
That’s a safe bet for him. It can’t happen.
Option 3: Printing Money
But, frankly, the most obvious and straightforward thing to do is this: print the money to pay their salaries. People typically react to this with shock, crying out, “But that will cause inflation!” No it doesn’t (for a more in-depth treatment, read my posts on inflation below).
The short story on inflation is this: printing more money can be inflation if no more goods and services are produced (but even then it doesn’t have to–see below). But remember that the whole point of raising the money supply here is to raise the volume of goods and services produced. We pay Isaac and John enough to make the production of goods from Kate’s factory profitable to her (and so that she hires Hannah, too). Hence, the level of output rises just as much as the volume of the money supply, and there is no inflation. Contrast that with the situation in a small, developing nation. Perhaps our productive capacity is such that we simply can’t produce enough for all ten workers, only Adam through George. In that case, giving jobs to Isaac and John just causes inflation–more money, but no more goods than before. That’s not the case in the US, however.
Technically, we cannot choose to simply print money to fund government spending in the US–but, de facto, we can if we use Option 2, and the Federal Reserve buys the debt (they are already the #1 single owner of federal government debt). Since they will pay with brand new dollar bills, the new spending is created with new cash. This creates new demand without draining it from somewhere else in the macroeconomy or creating the illusion of a burden on future generations (actually, the illusion might still be there, but I suspect that people are less worried about us owing the Fed money than the Chinese!).
I am horribly, horribly tempted to write more (in fact, I did, but I’m cutting it), but I really wanted to make this as short as possible while getting the main point across. So, I’ll stop here. My main points are these:
1) It is critical that the government generate demand in the macroeconomy if we are to reach full employment–and it doesn’t cost anyone anything for them to do so since we are starting at less-than-full capacity. If we don’t do this, then we are–I don’t know how else to say it–royally screwed. THIS is the key problem.
2) In a technical sense, we don’t need to “finance” any of the spending. In other words, it’s not necessary for us to find someone with extra cash to loan us. We can simply print it (or have the Fed buy the debt), and in fact that makes the most sense since our goal is to expand demand, not rearrange it.
3) Since the debt is issued in our own currency (Greek debt was not, incidentally), we cannot possibly go bankrupt. That concept does not make sense in this context.
A private budget is fundamentally different from the federal one. Going into debt with the former represents an attempt to purchase something we could not otherwise afford. The goal of going into debt at the federal level represents jump-starting what we could have already done in the first place if, ironically, productivity had been lower and Kate had needed all ten workers.
Unfortunately, we all have a gut feeling that debt is bad and surplus is good, but that’s because we are transferring logic from our own personal lives to the federal government. It simply doesn’t apply (it is, as Paul Samuelson once said, a myth that is useful only insofar as it imposes a cost on government officials who might have a little too much fun spending money). Furthermore, if we not only do not spend more money right now, but begin to cut back, then we are doomed to a Japan-like, decade-long period of recession. To be honest, I think that’s where we are headed. Not only do the Republicans, now in greater power than before, believe that is what we need to do, but Obama only disagrees with them in degree, not in principle. Remember how the Great Depression ended? The massive government spending from WWII. Only under such circumstances were we able to make people forget about what they think of as “fiscal responsibility” and focus instead on (inadvertently, of course) economic responsibility.
I have a funny feeling the Japanese aren’t going to save us this time.
P.S. We owe China so much money because of the trade deficit, not the budget deficit. See the discussions of the debt and deficit below.
You can find the original here:
Not sure what the first commenter on that page is talking about. This is hardly from the same school of thought that brought us the crisis.
Plan B for Obama on the economy
September 6, 2010 4:54pm
By Thomas I. Palley
TO: President Obama
FROM: Thomas I. Palley
RE: How to avoid stagnation and restore shared prosperity
DATE: Labor Day, 2010
With hopes of a V- or U-shaped recovery fading, there is the increasing prospect of an L-shaped future of long stagnation, or even a W-shaped future in which W stands for something worse.
The reason for this dismal outlook is economic policy is trapped by failed conventional thinking that can only deliver wage stagnation and prolonged mass unemployment.
Your administration’s current economic recovery programme has been marked by four major failings:
1. Inadequate fiscal stimulus.
2. Failure to cauterise the housing market
3. Failure to neutralise the trade deficit
4. Failure to restore the link between wage and productivity growth
If your policy team remedies these four failings our economy will quickly begin robust recovery. However, the longer you wait the greater the challenge, because recession creates new facts in the form of bankruptcies, foreclosures, destroyed credit histories, job losses and factory closures.
1. Let the Bush administration tax cuts expire and use the savings for additional targeted stimulus
The economy needs a further demand boost to establish recovery momentum. The majority of the Bush tax cuts were an income redistribution program favoring the wealthy rather than a stimulus or growth program. That makes extending them bad policy.
The Bush 10 per cent bracket and marriage provisions should be retained, while everything else should be allowed to expire with the savings used to fund new temporary fiscal stimulus.
Half the funds should be directed to state and local governments to help avoid another round of job losses, this time in state and local government. The other half should fund an immediate lump sum non-taxable payment to all individuals earning less than $50,000 ($100,000 for married couples). This means 80 per cent of households will continue benefiting and the total paid to these households will actually increase.
Moreover, the lump-sum design will increase the benefit going to those at the bottom, which will further stimulate demand and also lower income inequality. This temporary stimulus should be repealed once self-sustaining recovery is underway.
2. Cauterise the housing market
The second critical measure is to cauterise the housing market. Throughout the crisis, policy has disproportionately benefited banks and corporations. It has largely failed to help households directly and has instead relied on hopes of trickle-down effects from banks, combined with expensive tax subsidies to attract new home buyers.
The failure to directly help households has been a grievous policy error. Along with banks and corporations, households have needed debt relief but this has not been forthcoming. Banks have resisted meaningful loan modifications, while many households have been unable to refinance mortgages at lower interest rates because of zero or negative home equity. Consequently, the household sector has remained distressed and trapped in a foreclosure tsunami that has traumatised the economy.
Policy must immediately put a floor under existing homeowners. The solution is to use the Federal Housing Administration to refinance Fannie Mae and Freddie Mac mortgages with low or even negative equity and then have Fannie and Freddie repay some of their federal government borrowings. The test criteria should be whether the mortgage is viable once refinanced at low rates.
Additionally, the Federal Reserve must continue with purchases of mortgage-backed securities to ensure that mortgage rates stay low until the housing market has stabilised.
Refinancing such mortgages will yield a huge boost to the distressed corner of the household sector that is currently unable to refinance. It would reduce foreclosures; boost consumer demand by lowering mortgage payments; and it is urgent because adjustable rate mortgages issued late in the bubble are still resetting upward.
The problem has always been inability to service interest costs, and the foreclosure wave could have been avoided if lower interest servicing had been made immediately available to households. Policy did this for the business sector via the TARP and various Federal Reserve rescue facilities but failed to do so for households.
3. Neutralise the trade deficit
The third critical measure is to neutralise the trade deficit. The adverse effects of the trade deficit can be understood through the metaphor of a bathtub. Fiscal and monetary stimulus is being poured into the tub but that demand is leaking out through the plughole of the trade deficit. Moreover, it is not just demand that leaks out, but also jobs and investment due to off-shoring.
The trade deficit and off-shoring are significantly attributable to China’s under-valued exchange rate, which also forces other countries to under-value their exchange rates to stay competitive. This has resulted in an over-valued dollar which makes the US economy internationally uncompetitive.
As China refuses to correct its under-valued exchange rate, it is long past time for the US to take protective action. That can be done via administrative interventions and legislation to make countries with under-valued exchange rates subject to countervailing duties.
There may be trade disruption and retaliation, but the costs of inaction and appeasement are far worse. The problem of under-valued exchange rates was visible a decade ago yet policymakers have failed to take action with devastating consequences.
The choice has always been pay now or pay more later. Inaction means working families have already paid enormously and continued inaction will compound their devastation.
4. Restore the wage – productivity growth link
Finally, policy must address the central problem of the last 30 years: the destruction of the income generating process and severing of the wage – productivity growth link.
Rebuilding that link is critical to recovery and shared prosperity, and it requires rebuilding worker bargaining power. One immediate measure is passage of the Employee Free Choice Act that will enable unions to organise on a level playing field.
A second measure is to index the minimum wage to the median wage. That will create a real wage floor and limit wage inequality because the minimum wage will automatically increase as median wages rise with productivity.
5. Do it all
It is important these measures are enacted as a comprehensive package. Implemented alone they will be far less successful.
Without tackling the trade deficit, fiscal stimulus and the benefits from cauterising the housing market will leak out of the economy. Similarly, increasing union membership and wages will result in an acceleration of job and investment off-shoring.
Fixing the trade deficit without fixing the income generation process and lightening households’ debt burden will leave the economy permanently short of demand.
Escaping the Great Recession requires jumpstarting the economy by increasing demand. Preventing the economy falling back into stagnation requires rebuilding the income and demand generating process. That is why success needs the full policy package.
Thomas Palley is a Schwartz Economic Growth Fellow at the New America Foundation