Even a deal on the budget is bad for the American economy

By Marshall Auerback

Looking at the latest US data, business sentiment and capital spending have been eroding, and given the lagged impact of capex, that trend looks set to continue for the next few months. Against that, a number of consumer sentiment indicators remain upbeat and housing looks like it is in a firmly established uptrend, after a 5 year bear market.  In fact, the existing home inventory to sales ratio is as low as it ever gets, and that is with still very depressed sales. If sales pick up further, given low inventories and with new housing starts still below the replacement rate, home prices could lurch forward.

That said, the markets have been fairly upbeat given the rising perception of a deal to avert the US falling off the ‘fiscal cliff’. But even a deal that drains, say, 1-1.5% of GDP will have negative consequences for the US economy.  Bear in mind that the U.S. still has a very high ratio of private debt to GDP. Therefore any such fiscal restriction as contemplated by the two parties may result in a significantly lower economic growth rate than the average 3% rate of the last five quarters (which is what the revised economic data of the past few quarters will eventually show).

Of course, if there is no compromise, the impact could be calamitous.  The IMF projects as much as a 4% decline in GDP if there is a full fiscal cliff. In 1936-37 there was a fiscal cliff of almost 6% of GDP. It was followed by a 36% non annualized decline in industrial production in a mere eight months in late 1937/early 1938. More recently, all of the European countries fiscal restriction has had a more negative impact on GDP than had initially been forecast.

So the range of likely outcomes ranges from slowdown to outright recession and the silly thing is that it is all so unnecessary.  Social Security, Medicare and Medicaid impose no real burdens, even with a rising proportion of ageing baby boomers.  In fact, one could plausibly make the case that an aging society could help to generate favorable conditions for achieving sustained high employment with high productivity growth. As the number of aged rises relative to the number of potential workers, what is required is to put unemployed labor to work to produce output needed by seniors. Providing social security benefits to retirees will generate the necessary effective demand to direct labor to producing this output. Just as rapid growth of effective demand during the Clinton boom allowed sustained growth of the employment rate, even as productivity growth rose nearer to United States long-term historical averages, tomorrow’s retirees can provide the necessary demand to allow the United States to operate near to full employment with rising labor productivity—a “virtuous combination” of the high productivity growth model followed by Europe and Japan from 1970–95 and the high employment model followed by the United States during the 1960s, as well as during the Clinton boom.

Here’s what most members of Congress (and, indeed, the media and the public) fail to appreciate:  Policy formation must distinguish between financial provisioning and real provisioning for the future; only the latter can prepare society as a whole for coming challenges. While individuals can, and should, save financial assets for their individual retirements, society cannot prepare for waves of future retirees by accumulating financial trust funds. Rather, society prepares for aging by investing to increase future real productivity.  Unfortunately, no such discussions are taking place, which is likely to lead to a bad to horrific policy outcome.

They are transfers in current time. They meet today’s commitments to seniors, survivors, dependents, the disabled and the ill – commitments they have earned through work – providing them with income and services at the expense of others also currently alive.  This any community can always do, to the full extent of its will and resources.

The fiscal austerians are literally strangling the baby in the crib today by denying a sensible fiscal response for the current generation’s plight, while hyperventilating that fiscal deficits will do the strangulation of the next generation tomorrow.  All of which exacerbates a problem of economies facing intense global headwinds from private sector deleveraging.

Viewed from that perspective, the terms of the debate have been truly twisted around. Granted, it is obviously more difficult to make the case for more government spending when legitimate distrust reasonably exists of dysfunctional financial and governmental systems.  That said, what really matters is whether the economy will be able to produce a sufficient quantity of real goods and services to provide for both workers and dependents several generations down the road.  The financial aspects of demographics per se should not play a role in policy formulation.

Any reforms which seek to address growth in the context of private sector debt deleveraging and demographics ought to be made with a focus on increasing the economy’s capacity to produce real goods and services today and in the future, rather than on ensuring positive actuarial balances through eternity. Unlike the case with individuals, social policy can provision for the future in real terms—by increasing productive capacity in the intervening years. For example, policies that might encourage long-lived public and private infrastructure investment could ease the future burden of providing for growing numbers of retirees by putting into place the infrastructure that will be needed in an aging society: nursing homes and other long-term care facilities, independent living communities, aged-friendly public transportation systems, and senior citizen centers.

Education and training could increase future productivity. Policies that maintain high employment and minimize unemployment (both officially measured unemployment, as well as those counted as out of the labor force) are critical to maintain a higher worker-to retiree ratio. Policy can also encourage seniors of today and tomorrow to continue to participate in the labor force. The private sector will play a role in all of this, but there is also an important role to be played by government.

On balance, if we were to focus on only one policy arena today that would best enhance our ability to deal with a higher aged dependency ratio tomorrow it would be to ensure full employment with rising skill levels. Such a policy would have immediate benefits, in addition to those to be realized in the future. This is a clear “win-win” policy, unlike the ugly trade-off promoted by both parties, who only differ in the degree to which today’s workers and future seniors are to pay for the mistakes of the banksters through misguided proposals to “reform” entitlements and put our future on a “fiscally sustainable” path.

11 responses to “Even a deal on the budget is bad for the American economy

  1. Just interested, what makes you think there will be such a large upward revision of the past 5 quarters GDP data?

    Also, does the housing inventory to sales ratio account for bank-owned properties? I’ve heard it said that some banks are holding some foreclosed properties off the market, waiting for prices to rise.

    As for the main point, I fully agree. They are just arguing now about how steep the fiscal slope will be. Cliff or slope, we end up at the bottom, broken and battered, either way.

  2. Almost all the countries developed and developing are facing this aging problem (only in China currently 110 million are above 65 years of age) . Simply by increasing the retirement age by another four to five years does not seem to be solving the problem since in that situation young generation will remain unemployed or under-employed. Appropriate and feasible solution seems to be that we need to enforce birth control in such a balanced way that growth in population remains commensurate with the economic growth.

  3. Though you say the parties both want to cut entitlements I don’t see the basis for that. Which Democrats are-during these current talks, -on the reocrd as wanting to cut Medicare and Social Security. Many Democrats have said they won’t do it. I don’t agree that they’re ready to gut entitlements.
    There may not even be any grand bargain-just something small to keep the tax cuts for the nonrich. As for Medicare there are some good ways to reform it and make it more efficient-like the $717 billion in ObamaCare “cuts” Ryan and Romney ran against.

  4. The problem with your proposal is in your first sentence. Failure of a deal by the end of the year (or a deal to raise or eliminate the debt ceiling) and continued high deficits will leave business confidence low. Until you can convince business that the best way to grow the economy is high levels of deficit spending, this won’t happen.

    On the other hand, if a budget deal avoids the “fiscal cliff”, especially a long term deal, business confidence is likely to rise and investment along with it. There is plenty of money sitting idle ready to be used.

    • Business investment is a response to rising sales. It isn’t inspired by a confidence fairy, or by the owner’s political opinion about deficits, but by economic facts. Either government or consumers has to increase their purchases from businesses, and then they will invest. If government does it, the deficit will rise. In order for consumers to do it, they have to have higher incomes, and the way to get that by policy is either to increase transfer payments or reduce taxes, and the deficit will rise. Businesses don’t have to be convinced of anything in order to have increased confidence. They need to see the increase in sales, and that will inspire their confidence and their investment.

      On the other hand, a deal which puts us on a fiscal slope instead of a cliff, by increasing taxes and reducing government spending, will cause reduced business sales, and will not result in any increase in hiring.

      • Actually, businesses invest when they think that sales will increase or that a new product might sell. They don’t sit back and wait for sales to increase first. If they waited for sales before investing, there would be no startups (since most have no sales at all, let alone rising sales, when the initial investment is made). I can also assure you from first hand experience that large corporations will increase spending and investment when they anticipate sales, not in response to sales.

        Business investment depends much more on business confidence in the future than on short term sales trends.

        • It’s true that large corporations have product development plans that are independent of business cycles. And sometimes, like now, retail companies and some others can hire in anticipation of holiday sales or other seasonal factors.

          But, generally, when sales are stagnant or falling companies are not going to expand the factory or open a new one in the next town, or hire and train more employees. Even after sales begin to pick up, they will cope with increased demand by increasing hours for part-timers, or overtime for full-timers. They will lay on a second or a third shift before they invest in a new plant. Only when they are selling all they can make in their current plant, AND they foresee that sales will continue to increase, will they build a new one.

          But the point is that they invest in response to sales, whether current or anticipated, and not in response to their belief about whether the level of the federal deficit is proper.

  5. As for why there will be upward revisions, I base it in part on the huge discrepancy between the NIPA data on household savings and the flow of funds data, which suggests a MUCH higher savings rate. Additionally, Real PCE, though healthy over the last three months, is lagging retail sales only because of feeble growth in real services consumption. Typically, in economic expansions services consumption grows close to trend. That is even more likely when real PCE is growing close to trend, as happened over the last three months. That is even more likely when employment in private services is growing at trend. If one adjusts the payroll data on private services for the announced upward payroll revision to be implemented next March, hours worked in private services have been growing at about trend since Q2 2011.
    Yet, the BEA is telling us that the consumption of services is growing at half that rate. Sustained very negative services productivity does not happen in economic expansions. That is almost impossible in the real world.
    The BEA makes no bones about the fact that its first pass estimates on PCE services is little more
    than a guesstimate. Given the strong growth in services hours worked, it seems likely that services real PCE and therefore overall real PCE is being understated.
    If one sticks with the BEA’s data on miserable real disposable income growth, the NIPA measure of the household savings rate would be even lower. The massive discrepancy between the flow of funds measure of the household savings rate and the NIPA measure of the household savings rate would be all the greater. We would have close to a modern era record high on the flow of funds savings rate and close to a record low NIPA savings rate.
    Putting all of the above together, it is hard not to conclude that there is a very major underestimate of household income and its growth in the U.S. economic statistics over the last year and a half.