The United States Can Prevent Economic Disaster, but It Won't

The U.S. economy is in bad shape now. In spite of upward blips, it is going to get worse, with results ranging from dismal to dreadful. The underlying reasons are embedded in the political economy of the U.S. and the world; the Republican electoral victory, caused in large measure by the basic economics, will accelerate the downward spiral.

Policy can prevent the worst, but it won't, for three reasons.

  1. The simple policies discussed below will not work as straightforwardly as the narrative might make them seem. 
  2. Fears for the "long run" impede what can be done in the short run.
  3. The problems are global; policymaking is national.

These three factors are real in themselves, and they combine to produce the political phenomena, exemplified by the Republican sweep, that will preclude implementation of the policies.

The Cause of the Problem

Economists are known for fighting hard over their disagreements, but in the simplest terms, they agree over the cause of economic fluctuations.

If producers have the resources--labor, capital goods, materials--to produce more goods and services than buyers want to buy, the result will be a downturn--a recession. If buyers want to buy more than producers can produce, the result will be inflation.

Downturns have been triggered by the collapse of speculative bubbles based on unjustified beliefs that buyers (including other speculators) would purchase rapidly increasing supplies (including supplies of financial instruments); or by increases in productive capacity not matched by increases in desires to buy. Inflation has been caused by rapid increases in buying (e.g., of armaments in wartime), or decreases in productive capacities (e.g., when the 1970s oil boycotts reduced production in oil-using nations).

The current recession came about because the collapse of the housing/financial bubble led buyers of consumer and capital goods to cut their buying back to below what producers could produce. (Dealing with such bubbles raises issues different from those discussed here.)

The Solution The definitional remedy for recession is to bring purchases back into balance with potential production. This could be done by reducing production, but that would reduce employment, which is the problem, not the solution.

Therefore someone must buy more. An economy has three sets of domestic buyers: consumers; business buyers of capital goods; and governments, national and local. Additional purchases can come from abroad--exports--but of course domestic buyers may import, which will not help the national imbalance.

One way that domestic buyers may be encouraged to buy more is by monetary authorities--in the United States, the Federal Reserve--putting more money into the economy and lowering interest rates. But if consumers are scared and capital goods buyers see few opportunities to profit from purchases, the money will be saved rather than being used to buy more. This is frequently termed a "liquidity trap". At the moment, it seems to have ensnared most western economies.

(Monetary policy is not symmetrical, however. Liquidity traps can vitiate it on the downside, but when inflation threatens, tightening the money supply and raising interest rates will discourage spending. That was done by the Federal Reserve during the Carter and again the Reagan administrations.)

In any case, the inefficacy of monetary policy in combating a downturn like the current one makes government deficit finance essentially the only alternative. If governments spend more than they receive in taxes--more for roads, for education, for arms, for space stations--they decrease unemployment by employing people directly or by buying things that employed people make; the employees will decrease it further by buying more things. Spending on welfare and suchlike does not employ people directly, but recipients are quite likely to buy things. The same is true for tax reduction--if the beneficiaries spend their now untaxed money,

In the United States, only the federal government can run substantial and continuing deficits. For reasons of their own constitutions and because nobody would lend to them for such purposes, the states must maintain balanced budgets. Indeed, state spending cutbacks because of recession-caused revenue reductions are a major factor intensifying current problems.

Deficits are financed by borrowing money that would otherwise be unspent. Domestic borrowing will be mostly from banks, which in a recession have few alternative opportunities to lend to scared consumers and discouraged business buyers; or from the Federal Reserve, which can create money by saying it is there and lending it out, mainly to the federal government. Government borrowing from the Fed is the modern equivalent of printing money as was advocated for similar reasons by the Greenback Party a century and a half ago.

Historically, it is argued that deficit financing in the 1930s did not turn around the Great Depression, and the argument is correct. But immense war-driven deficit financing in the 1940s did end the Depression; the government just had to spend enough.

The simple answer is therefore clear: governments--in the United States, the federal government--should increase deficit spending until the recession is turned around, even if it takes a long time and a long string of deficits.Why then is it not really so simple, not really so clear, and not going to happen?

Three basic economic and structural reasons, producing and intensifying three more political ones:

1. It's not that simple. A lot of reasons are adduced for why the deficit-spending solution won't work. But the best of them come down to one point, almost as simple as the one it opposes: deficit spending, instead of adding to total spending, may drive out other spending. In particular, it may substitute for private capital spending. The mechanisms usually cited for such substitution are monetary, operating through higher interest rates. (One counterargument, however--more frequently heard a few decades ago than it is now, but worth reviving--is that increased consumer demand will stimulate capital purchases to make the newly-demanded consumer goods.)

In any case, fear of substitution is not a very good current argument. As noted, buyers of capital and consumer goods are not buying, even though monetary policy is trying to make it easy. It may be a much better argument in a somewhat longer perspective, as buyers come back into the market and compete for funds. Which brings up the next reason for questioning the deficit solution.

2. Deficit finance can cause long-run problems. When private buying does revive, political and other reasons may make public buying difficult to turn off, and even to the extent it can be, it will leave behind it reverberations--e.g., higher interest rates, and government spending to pay the interest on the borrowing that has taken place. The results can include reduction of capital and other spending that would have taken place, and inflation caused by competition between public and private spending.

Presented by

Robert A. Levine, an economist with the RAND Corporation, was deputy director of the Congressional Budget Office from 1975 to 1979.

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