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The Deficit Spending Trap

Written by admin | May 25, 2013

deficits-by-political-party-082511Recently, Bill Craighead, published a very good article entitled “The Wrong Budget Analogy” where he stated “The fact that high unemployment and budget deficits are occurring at the same time has generated confusion about the real sources of the slump. The increased deficit is a consequence, not a cause, of the downturn. When economic activity falls, so does tax revenue. Some categories of government spending, such as unemployment benefits, automatically rise during a recession. This contributes to a higher deficit.”

This is correct and, as I have discussed many times previously, the recent battle in Congress over the budget was the wrong fight to be having.  What is not understood by most economists, and our Administration, is that this is NOT a normal business cycle recession like those that we have witnessed post World War II.   This is a “balance sheet” recession very akin to the “Great Depression” where the economy was deleveraging debt, both Federal and public, back to levels that are fiscally manageable.  Only then can consumers, once they have access to credit again, return to normalized expenditure patterns that are crucial to the organic economic cycle. 

A “balance sheet” recession diverts normal savings into the payment of debt rather than consumption or, more importantly, productive business investment.  This is why the recent payroll tax reduction had no net benefit on the economy as consumers either saved the funds or paid down debt.

Craighead goes on to state that; “Decisions about the federal budget are fundamentally different from those of individual households, because policymakers need to account for how their choices affect the economy as a whole. It is more appropriate to liken government budget deficits to prescription medicine. Just as medication can be helpful to a sick patient, deficits can aid a failing economy.”

In theory this correct.  When looking at the current U.S. economy it would be simple to assume that it slumped largely because of a reduction in spending by households and businesses. Households’ direct response to an economic decline is to curtail spending. However, when that decline is compounded with job losses, threat of a job losses, lower household values, inability to obtain credit and inflationary pressures due to rising commodity prices, the retrenchment is much more severe.  Businesses, in turn, react to the final aggregate demand from consumers.   As demand wanes, businesses take on a defensive posture to protect profitability.   In turn they began to reduce employment, cut back investment, reduce wages and salaries and cut costs where ever possible.   These reductions then cycle back to the household in virtual spiral that becomes very difficult to break.

This brings us to the trap of deficit spending.  Craighead correctly states that; “To stabilize the economy, the federal government needs to counterbalance the swings in consumer and business expenditures by moving in the opposite direction. When consumers and firms cut back, government can help replace the lost economic activity through direct spending (on infrastructure projects, for example) and through indirect means, such as tax cuts, which increase households’ disposable income.”

velocity-of-money-082511The problem, again, is that we are not in “normal” business cycle recession where increasing households disposable income on a temporary basis, or direct spending on one time projects, transforms into longer term economic growth.  While these types of temporary fixes will drag forward future consumption, the problem becomes that as soon as the injection has run through the system, businesses and consumers go back on the defensive.   This now leaves the deficit larger than it was before without the benefit of continued increases in revenue from a revived economy to offset the increased spending.

The velocity of money, which is the rate at which money is moving through the economy system, is a reflection of this problem.  After several stimulus programs, tax cuts and extensions, there is no demand by households or businesses for credit.   There is a high correlation between the velocity of money and household debt relative to GDP.

reign-of-greenspan-082511As the economy began to shift from a manufacturing- to a service based-economy  the multiplier effect of invested dollars declined.  This in turn eroded economic growth and businesses scurried to increase productivity by lowering wages and benefit costs.  We can clearly see the extreme correlation  between these two events.  With lower wages came the need by households to acquire debt, of which the banks were all to ready to extend, to fill the gap between income and expenses.  Fast-forward thirty years and heavily leveraged balance sheets have to be unwound either through pay down, default or bankruptcy all of which are negative detractors from economic growth.

This is THE problem for the government.  While this is the time that we should be implementing deficit spending to shore up the gap while the economy recovers – the government has been blindly indulging in deficit spending during the boom years of the 80’s and 90’s.  Rather than building up a reserve for just such an occasion as we face today; the country is pushing a $1.6 Trillion deficit which will get worse as the government embarks on spending cuts which lowers future growth.  

Finally, the issues with deficit spending on things like temporary tax cuts, work programs, etc. is that they are temporary.   What has to be understood is that this is not a normal business cycle recession and temporary measures will only have the effect of delaying the inevitable deleveraging of the balance sheet.  The tug of war between businesses and consumers will remain as long as virtual spiral remains in tact.   Unfortunately, the current administration and government policy makers only seem to have a single prescription to draw on based on a normal recessionary enviroment.  Unfortunately, it is the wrong medicine for the illness that plagues the patient.

In order to cure what ails this economy the government needs to turn away from quick fix, bail out, solutions… they won’t work.  In order to get a long term economic “fix” in place there are several things that are required:

  • Time and Patience:  The deleveraging process has to complete its cycle and that will just take time.  What is important is that the government stops doing things that exacerbate the problem such as QE programs which create more inflationary pressures on consumers. 
  • Instead of “Shovel Ready Jobs” – bring home manufacturing: “Shovel Ready Jobs” are a temporary fix.  Once the job is completed it no longer contributes to economic growth.   However, provide permanent tax credits for businesses that begin to manufacture more than 90% of the products in the U.S.  This will allow manufacturers to become more cost competitive with foreign manufacturers and create jobs domestically.
  • Reduce Government regulation:  In addition to tax credits, reductions in the excessive levels of Government regulation are required to allow businesses to operate more efficiently.   Regulation has gotten out of control over the last decade and now must be reduced and reformed.  Review all regulations and repeal any and all regulations that are restrictive to business growth and job creation.   America can not compete effectively with foreign countries for manufacturing due to the extreme costs of compliance with the multitude of regulations currently required by the Government.
  • Reform the tax code:   This has been a huge topic as of late and long needed.   The tax code is restrictive and ineffective.  Lower tax rates with an elimination of “loop holes” will provide for higher levels of revenue to the Government.
  • Reduce dependency on foreign oil:  Focus on domestic oil and gas production to offset needs for foreign imports.  By establishing a clear and defined energy policy, while reducing barriers to domestic production and refining, the economy would benefit in several ways:
    • 1) more than 3 million jobs would be created,
    • 2) higher tax revenue would be received by the government, and
    • 3) oil and gas prices would come down which would help consumers by reducing their costs.
  • Repeal laws and bills that unnecessarily increase governmental intervention and oversight:  The list is long but some examples are Sarbanes-Oxley and the Frank-Dodd Regulatory Reform Act.  There are laws already in place on the books for malfeasance, fraud and theft.   Enforce the laws rather than create new regulations which are expensive and restrictive to comply with.   The Federal Accounting Standards Board is responsible for making sure accounting firms adhere to  Generally Accepted Accounting Principles.  Time to get rid of “operating” and “pro-forma” earnings and return to basic “reported” earnings.    If a company commits fraud, theft or runs a “ponzi” scheme, including banks that are TBTF, then that is what the U.S. Justice Department is for.

These are just a few of the many thoughts and ideas that would go a long way to getting the country back on the path to economic growth.  However, it will take quite a long time to resolve thirty years of “bad behavior.”   It is time to set aside bipartisanship and come together, not just in Washington, but as a country.   The strength of this great nation was built upon the “American Spirit” and the drive of each and every American to succeed in times of turmoil.   America is being called on once again to rise up and band together rather than pointing fingers at each other in blame and hoping for a “bailout” to solve their problems.

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