The Economic Vision of Obama's Second Term: The "Grand Bargain" or Prosperity Through Austerity

Austerity, in the form of forcibly moving the federal budget closer to balance despite the presence of high and sustained unemployment, will in no way or form assist the American economy.
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The president gave a rousing speech yesterday before the annual retreat of the House Democrats. As is appropriate for such an occasion, his speech was light on details, with the focus on his vision of the priorities for the upcoming Congress. Immigration reform and gun control were only briefly mentioned at the end of the speech, suggesting their secondary importance. What, then, was the dominant theme? The budget deficit. Specifically, the president renewed his commitment to achieving what he called a "Big Deal" (formerly, the "Grand Bargain") with Congressional Republicans to reduce the government's budget deficit. Taking a "liberal" position on the issue, the president rallied his audience by insisting that the wealthy should be asked to pay more as deficit reduction "shouldn't be just on the backs of seniors, it should not just be on the backs of young people who are trying to get a college education, it should not just be on the backs of parents who are trying to get their kids a better start in life."

Now, to be sure, the federal government's annual deficit (total spending minus total tax revenues) over the past several years has been substantial, coming to over $1 trillion per year in a $15 trillion dollar economy. The Bush tax cuts, the dot-com crash, several wars, and the greatest economic debacle since 1929 all proved to be expensive indulgences. On that, we can all agree. But the size of the deficit - in and of itself -- is not a compelling issue. By contrast, economic prosperity and employment are the stuff of daily life, and for that reason much more substantive in the minds of voters. One might think that the latter would be the primary concern of politicians, but conventional rhetoric suggests otherwise.

Why, then, is the current deficit such a heightened concern? The only discernible reason is that the leadership of both major political parties has come to believe something like the following: The U.S. economy will grow at a faster rate if the federal government's annual deficit is reduced.

Now, if such a conjecture is to hold true, it must be the case that a reduced deficit does something that, in turn, facilitates more expenditure on goods and services. These increased expenditures would then induce private sector firms to hire more people. Given how important deficit-reduction is to our political classes and the media who hang on their every word, it would be reasonable to suppose that the growth mechanism that underlies it should be able to withstand "the grin test." Let's see if it can.

To begin, consider the following proposition. For somebody to earn, someone else must spend. This proposition might seem trite, but a lot follows from it. For example, from the perspective of the economy as a whole, we are all each other's customers. As a matter of simple accounting, the aggregate of expenditures in the American economy in any given year is the sum of: (1) Consumption of goods and services by households, (2) Investment in productive capacity by firms, (3) and Government spending on goods and services (government transfers show up under consumption; also, for ease of exposition, exports and imports will be ignored).

To return to the question at hand, can we describe a plausible argument wherein a reduced government deficit enhances economic growth? Let us consider this question in light of the above list. If the president and the Congress achieve the long-sought-after "Grand Bargain" then, by definition, government expenditures and consumption should each decline.

Government spending would decline by congressional decree and consumption would decline because taxes have been increased and/or transfer payments such as Social Security or unemployment insurance have been reduced, leaving its former beneficiaries with less to spend. However, the story goes, lower spending in these sectors should be more than compensated for by increased expenditures elsewhere in the economy that would be expected to occur as a direct consequence of the reduced deficit. That induces the next question: what types of spending will increase, and why?

The answer usually given begins by noting that government deficits must be financed by borrowing that, supposedly, reduces the loanable funds available for the private sector. The ensuing scarcity of funds, it is claimed, causes the prevailing rate of interest to rise. This higher rate of interest "crowds out" private-sector borrowing, thereby reducing expenditures on interest-sensitive consumer items such as automobiles, furniture, and homes. It also reduces productive investment in plant and equipment by private-sector firms. If we were to accept this line of argument, we would expect a lower deficit to reduce the government's demand for loanable funds, causing the prevailing rate of interest to fall, thereby enabling the private sector to flourish.

These last two paragraphs represent the core of the theory (although most economics professors like to dress it up in math). To reprise the standard argument, a reduced government deficit does subtract from total expenditure, but this shortfall can be expected to be momentary as it will be more than compensated for when the ensuing lower rate of interest provides its tremendous boost to interest-sensitive forms of consumption and investment, thereby reviving the economy and employment to the satisfaction of one and all.

Now, let's bring some facts to bear. On Feb. 7, 2013, markets closed with the posted interest rate on the 10-year U.S. Treasury Bond at 1.99 percent. It is hard to see how such a fantastically low rate represents a barrier to borrowing. Frankly, at such rates the government should be borrowing more, not less. But wait. Surely the rate at which firms and individuals borrow is much higher? To get a sense of the "spread" between the government and private sector, we might ask what banks charge for a 10-year fixed rate "conforming" mortgage. The answer? Most banks are showing 10-year fixed rates under 3 percent. To be sure, this is 50 percent higher than the rate at which the government borrows. However, by any other standard, it is amazingly cheap money. It is hard to imagine that such rates are preventing people from entering the market. However, for a final check, let us take a look at car loans. Here we find that for people with good credit, most banks are charging a fixed interest rate of less than 5 percent for a 48-month loan. Once again, it is hard to suppose that these historically-low interest rates are a barrier to private-sector borrowing and economic growth.

Armed with the above knowledge, let us return to our story. Recall that the budget-balancer's line of argument is that the government's borrowing is placing such an enormous strain on the market for loanable funds that regular customers and businesses are being effectively shut out by high rates. Reducing the deficit will, in turn, lower rates thereby contributing to higher levels of employment. Again, for this narrative to make sense, high interest rates must be suppressing private-sector borrowing and expenditure. The evidence just doesn't support the story.

The point, should it not be clear, is the following. Austerity, in the form of forcibly moving the federal budget closer to balance despite the presence of high and sustained unemployment, will in no way or form assist the American economy. Indeed, given the virtual certainty that a reduced deficit will have no effect on already-historically low interest rates, the most likely consequence of austerity, independently of whether or not the burden is shared "fairly," will be to exacerbate our nation's economic malaise. The president and the Congress are each, in their own way, asking one or another segment of the citizenry to "sacrifice" current income so that we may earn less in the future. It is hard, really hard, to think of a more futile policy.

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