Sunday, June 12, 2011

Why the "growth strategy" won't work

Can you grow away the deficit? Recently I have read articles by supposedly economic experts suggesting that if the US could only get back to the growth it had during the 1960’s, the problem with the deficit would go away. So, the solution isn’t to reform entitlements, cut defense spending or anything else unnecessary. All we have to do is to invent a time machine that will bring us back to the age of Beatles. No, seriously, they rarely talk about how the economy should get back to those levels so it’s anyone’s guess. In reality, of course the postwar boom isn’t coming back (it was caused by a World War, remember, and those are kind of rare nowadays).

The general question is broader: Is it possible for growth to solve the debt problem? If only the world economy would recover, would that solve everything?

No, for a couple of reasons – let’s start with the most obvious ones:

1) Growth only causes the debt to look smaller on paper. Debt is typically measured in terms of % of GDP. If GDP grows while the debt burden doesn’t increase (or increases by less than the GDP grows), the debt will look smaller. Yet, tax revenue is far from certain to grow at the same rate as GDP. Sometimes, GDP growth is caused by tax cuts, which means that tax revenue falls even as the economy booms – and the ability to pay back your debt after all depends on how much revenue you have, not GDP. But on the paper, it looks as if the debt is going down as GDP goes up. In reality, it’s more complicated (I’m writing a thesis on the subject).

2) The US is driving the world economy, still being the only superpower in the world. The US cannot wait for someone else to lift, because everyone else is waiting for the US to lift (I’m not kidding – governments in Europe are currently claiming everything will be alright as soon as the US economy recovers).

Now, that being said, let’s get to the real issue here: Deficit spending doesn’t always cause growth, not even in the short term. This is what these economists assume. If that was the case, then deficit spending could be paid for by the increased revenue that comes from the growth that the deficit spending caused. Problem solved – except that that’s not how it works.

When a country spends more money than it has, two things happen: First of all, total consumption goes up, which is good. But at the same time, the government is after all borrowing money from the same pool as private investors. So when the government borrows more, that means the private sector has to borrow less. Interest rates go up (the interest rate is really just the price of money – with a higher demand for money, of course a higher price will follow), and this leads to less investment. The average Joe who was thinking about starting a company now finds it prohibitively expensive to borrow money, because the government has sucked up the capital he needed to finance the deficit (which they justify by saying they are stimulating the economy… how ironic!). Which one of these effects is the biggest? It depends.

If the debt burden is low, the effect of deficit spending (short term) will still be positive, because interest rates won’t go up very much. The government borrows $100 billion, interest rates go up 0.1 % and $50 billion worth of investment is lost.

If the debt burden is high, as is the case with the US, the effect will be negative even in the short run. The government may borrow $100 billion, but interest rates now increase 0.3 % (which is more than you’d think) and now, investment falls by $150 billion. Of course it’s not as straight-forward as I make it look, but that’s the general idea. There are good reasons why the government shouldn’t borrow even when it has a positive short run effect; it’s mainly because, well, it practically never has a positive long run effect. The thing is that if the debt burden is low, there will still be a lot of money left for private investors and overall interest rates won’t be affected very much, but if it is high, the negative effect of the higher interest rates will outweigh the positive effect of the boosted consumption.

The bad news doesn’t stop there: Expectations can cause the economy to slow down even before the deficit spending has occurred if investors believe that 1) The government will run a deficit and 2) This will raise interest rates significantly.

You are less likely to take a loan if you believe interest rates are going to be higher in the future, and so fewer investments will be made as soon as expectations about the future change, even before interest rates have gone up. If the government acts in a way that makes investors (foreign and domestic) believe that the US will never balance its budget, they won’t wait for interest rates to go up, they’ll just stop investing right now. And that is, essentially, what they are doing. No-one is making any long-term decisions right now because the outlook is too uncertain, and since hiring is a long-term decision, no-one is hiring. Hence; a jobless recovery where many short-term investments are made that keeps dividends coming and stock prices at decent levels, but no hiring since that’s a long-term investment which is seen as too much of a gamble.

Growth isn’t sure to lead to a balanced budget, in particular not when tax revenue would have to increase by about 50 % in order for that to happen (or, spending would have to fall by around 33 % - but that’s even more unlikely given the political environment). Waiting for growth to return just doesn’t work anymore, partly because it’s unlikely to return just by itself, partly because it wouldn’t bring with it the massive increase in revenue that is necessary. In the meantime, the US needs to come up with a plan that will balance the budget quickly. This has to be done before investors actually start to expect (realize?) that the government isn’t serious about dealing with the deficit, and that it never will be serious about it (I’m actually starting to think Obama would rather default than reform entitlement). If that happens, all hope is lost and it will be a downward spiral from there. I will deal with the consequences of a US default in a later post. This is enough for now, hope you enjoyed reading and that you understood. If not, please ask a question and I’ll get back to you.

1 comment:

Anonymous said...

I have two comments about this article. First, part of the post war boom was because people had accumulated a lot of savings that they simply couldn't spend earlier. When regulations finally eased in the 50's, people used their savings to purchase goods and services and better their lives. They also managed to help better each other's lives by stimulating the economy. Without savings to spend, it is more difficult to achieve the same type of boom based on debt, which is how most of our economic booms have been achieved in the last couple of decades. Just look at the housing crisis!

My second point is that in a booming economy, tax revenue often does go up in spite of tax cuts, although it may have some lag time between. You should check this out. It's part of why John F. Kennedy was in favor of tax cuts to stimulate the economy. It simply isn't true that the government suffers from giving tax cuts. Although, the gov't has never really achieved living within its means, so its irrelevant how much gov't takes, they are always "underfunded." I don't know why they can't understand that I am "underfunded," too!