Should Obama Spend Or Save?

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Data from the US Department of Labor released in the first week of June presents a dismal picture of the US labour market. Although the official unemployment rate has dropped consistently for the last eight months, there were only 50,000 new jobs created in May 2011, far below the expected 150,000. 

There are further concerns that the unemployment rate does not reflect the increasing number of people in the US working more than one job to make ends meet, or who have become "discouraged" and left the job market. None of these people show up in official statistics. What they represent is unused capacity in the US economy — and significant personal and social costs.

These poor employment showings are not enough to conclude that the US economy is done and dusted. What these figures do highlight is the policy dilemma now facing US lawmakers. The US is torn between continuing to support aggregate demand in the economy in the hope of easing the squeeze on workers, and consolidating finances with the hope of facilitating a more sustainable, longer term recovery — but possibly risking prolonged unemployment. That is, the US needs to balance management of skyrocketing public debt against high unemployment and excess capacity in the economy.

In our last article on the US economy for New Matilda, we argued that despite reaching its arbitrarily imposed debt ceiling, the US government is unlikely to default on its debt in the near future. This is because of the continuing appetite for US dollars in global financial markets which gives the government considerable room to borrow to meet its interest repayments. In fact, since our last article, US bond yields have declined further, making it even easier for the US to continue borrowing at a less costly rate.

But the US cannot borrow its way out of trouble indefinitely. At some point the massive public debt needs to be acknowledged. At risk of sounding like Truman’s irritating two-handed economists, let’s take a simple look at two key perspectives on the debate.

On the one hand we have an essentially Keynesian argument that promotes the role of the state as a "demand manager". Keynes quite rightly pointed out that there is no particular reason for markets, as we commonly experience them operating, to act efficiently and to maintain "full employment". In fact, it is quite easy for the economy to slip into recession. The role of the state is therefore to either pre-empt the recession or to ameliorate its effects and prompt a faster recovery by increasing government spending.

Applying this theory to the US economy at present, the government would be well advised to continue to bear the pain of its fiscal deficit and not wind back spending just yet. According to Keynesians such as Paul Krugman, the present problem in the US is cyclical unemployment, not the budget deficit, and any premature reduction in government spending will only lead to a further recessionary spiral.

Keynesian policies were in vogue during the 1960s, but orthodox economists began to focus less on demand management as supply side issues caused significant global shocks in the 1970s. Critics of the Keynesians argued that the state should steer clear of entering the market to stimulate demand and instead pursue micro-economic labour reform, taxation structures that are conducive to private enterprise, and institutional arrangements that support longterm productive capacity.

There are two technical criticisms of demand management. The first argument goes something like this: government spending financed by borrowing increases interest rates, making it harder to for private investors to get access to capital. Government deficits thus effectively "crowd out" investment. Even if interest rates do not rise, there is an argument that consumers and businesses watching governments spend up big can also be spooked into reducing their investment.

And then there’s Ricardian Equivalence, the theory that today’s government spending is tomorrow’s taxation. Increased government spending thus causes consumers to reduce their current consumption in order to save to meet their future tax liabilities — thus offsetting any stimulus benefit.

Both crowding out and Ricardian Equivalence have been widely criticised — and not just by Keynesians. However, the empirical research has still not been conclusive and the debate is far from over.

Government borrowing today must have some impact on consumption patterns and decisions about future investments. Even if we accept that state intervention can and does reduce the harsh effects of economic failure — especially for those citizens and sections of the economy who are least able to adjust to changes — it does not follow that all government spending is good government spending.

The issue of demand management is ultimately a political question: should the US continue to deal with economic crisis through increasing government expenditure and if so, how should such spending be managed? If fiscal consolidation does not happen now, can the US government play the economic cycle and rely on markets to "correct themselves", or is a cyclical response inadequate? Are there more deep-seated, structural changes that need to be made to complement a cyclical response?

At present there are enough Democrats who are uneasy about large levels of US debt siding with Republican Tea Partiers fanatically opposed to almost all forms of government expenditure to make it almost impossible for the government to justify increased spending measures.

Equally, can the US risk the further deterioration of current recession in pursuing policy objectives focused on the longer term debt problem? Protests underway in Europe indicate low public tolerance for such policies. He may have overseen the assassination of Osama bin Laden, but Obama is facing a re-election campaign. Reports that working class Americans are bearing the brunt of fiscal consolidation policies won’t help him in this regard.

The economic crisis has opened a debate about the structural issues affecting the US economy. If the US government is to focus on demand management, it should use its significant consumption power to prompt longer term changes in consumer and business behaviour. This could involve improving efficiency and promoting investment in productive activities, rather than investment in speculative, ephemeral sectors of the economy that attract skills from sectors of the economy that actually produce "stuff". This should be coupled with intelligent tax reform that may even have some immediate stimulatory effect. Taxes on desirable and productive economic activities could be reduced, for example, and replaced by taxes on socially and environmentally damaging  activities.

This crisis provides a unique chance to learn from experience and to question the markets that have been constructed. Some convincing evidence has been provided that the systemic problems generating recession can be exacerbated by cyclical downturns. Addressing the unemployment rate is important but it is not the end game; improved living standards and a more sustainable, efficient economy should be the goal. To that end, the US needs to move beyond simply trying to figure out why the markets didn’t just fix themselves and pursue deeper institutional economic reform.

 

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