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 the policy will not be adopted and the solution not work

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.

This is a better argument against deficit finance. One counter-argument is that the future is so uncertain that the negatives which might happen, also might not, for many reasons. But the major counter is based on a philosophical/political preference rather than any economic analysis--a preference for immediate melioration of current severe economic and human problems, over worrying about an uncertain future. That is my own preference, but it is not necessarily shared by a majority of Americans.

3. The problems are global, policymaking is national. This is the major reason why the ideal solution will not work, even if it should. Even during the Great Depression, it was almost impossible to "protect" a national economy ("almost" because Hitler did it, but his means are not recommended), and attempts to do so had the major effect of spreading the pain without decreasing it. Now, the unstoppable international movement of information, capital funds, and even labor makes such insulation much more difficult.

The result is that the impact of a unilateral U.S. attempt at revival by deficit financing may be dissipated abroad. The 2009-2010 Obama administration stimulus package had a crucial effect in stopping the accelerating downturn in the U.S., but, as reported by Reuters in July 2010, " Economic growth slowed in the second quarter as companies invested heavily in equipment from abroad and the pace of consumer spending eased, raising concerns about the recovery in the rest of 2010."

The problem is that major competitors, notably the European Union, have been following (albeit sometimes reluctantly) the leadership of Germany, which is trying to revive itself by exporting rather than encouraging its own consumers. This is done by constricting while the U.S. stimulates. Japan similarly depends on exports rather than its own people. Interestingly, China, potentially the most dangerous competitor, is trying hard to increase domestic consumption, although also continuing to protect its exports by manipulating its currency.

The three objections are real: substitution is at least a potential threat; the short/long-run dilemma cannot be overcome by economic policy; the global problem exists. And these three realities are exacerbated by three factors that might possibly be change, but not in time: ideology and false analogy which together with the fundamentals have joined together and will continue to do so, producing a political blockage unlikely to be overcome:

4. A Puritan ideology that it is dangerous and immoral to "spend beyond one's means". This is strong in the United States; it is even stronger in Germany, still haunted by the hyperinflation of the early 1920s (suffered under completely different circumstances), which many Germans believe brought Hitler to power.

5. Closely related is the analogy that since a family cannot long spend what it doesn't have; neither can a government. But a family cannot print money; a strong government overseeing a fundamentally strong economy can. The U.S. today bears no resemblance to a defeated, reparations-burdened, Weimar Germany (nor does Germany today).

Which leads to the politics of the last two years which brought about the Republican victory, and the politics of the next two years that may lock it in--and lock in with it, economic disaster.

6. The ideological factors plus the constitutional structure of the United States, enhanced by archaic rules, have empowered a blocking minority to prevent the necessary continuing stimulus. That will now get worse. The Republicans in Congress, motivated by ideological and real economic beliefs shared by most Republicans, and a drive to win by making the Obama administration look bad, shared by all, have blocked the needed stimulus program. And it has clearly worked, politically. The administration failed to turn the job situation around. (The non-partisan Congressional Budget Office has pointed out that Obama stimulus did stop the downturn from becoming much worse, but that is theory. Political perception inevitably compares what is to what was, not to what might have been.). As a result of the failed turnaround, the Republicans now share control. Whatever minor compromises are made in the next two years will not be in the needed direction.

My advice to the Obama administration would be to make job creation through stimulus an issue nationally; and internationally too, using threatened protectionist sticks as well as reasoned arguments. This would at least draw the lines clearly when the 2012 election takes place under miserable economic conditions. The opposite--and likely--course, trivial compromise in an atmosphere of harsh partisanship, will have no favorable economic effect and lead to no political solution.

But the needed solution--continuing global stimulus--is really and completely out of reach. So what happens next? Three possibilities:

• A deus ex machina, or outside, at least, of any of the competing macroeconomic models discussed here. The Austrian-American economist Joseph Schumpeter contended that economic growth come in waves, stemming less from economic factors as such than by entrepreneurs exploiting new technologies, broadly interpreted. This started with the Industrial Revolution; the latest wave has been the Information Technology Revolution; when the next one will arrive, or from where, is not predictable, at least not by an economist. Perhaps from China.

• Years of what the American Keynesian economist, Alvin Hansen called, as the Great Depression wore on, "secular stagnation"--continuing grinding slow growth and high unemployment.

• The solution that ended the Great Depression--World War.

The first of these is not predictable. The other two are not desirable. Welcome to the third millennium.