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By Marshall Auerback

This is a post which I originally published at New Deal 2.0.

Ed mentioned earlier Friday in the links that I was going to post to add some variety to the discussions at Credit Writedowns. So, here is an article on Spain and the EU which demonstrates deficit terrorism in action – coming soon to a TV screen near you in America.

Speaking of President Obama, Karl Rove writes:

After a year of living in his fiscal fantasy world, Americans realize they have a record deficit-setting, budget-busting spender on their hands.

Well, given his history with former President Bush, it certainly takes one to know one. But it is hard to understand how the concept of “budget busting” applies to a government which, as a sovereign issuer of its own currency, can always create dollars to spend. There is, in other words, no budget to “bust”. A national “budget” is merely an account of national spending priorities, and does not represent an external constraint in the manner of a household budget.

A Deficit Spending Limit Disaster

What do commentators such as Mr. Rove really think would have happened if there had been tight fiscal rules in place preventing any (or only some) discretionary response in net spending? Consider a real world example. In December, Spanish unemployment rose to 19.3% (the highest in more than a decade), capping a year that saw the nation’s jobless rate soar to double the Euro- zone average. According to the Merco Press, the number of people registering for unemployment benefits increased by 54,657, or 1.41 percentage points from November to 3.92 million. From a year earlier, unemployment climbed by 25%; youth unemployment is now 40 per cent. The only good piece of news this year was that the number of jobs destroyed in 2009 was 200,000 less than in 2008. That’s the sort of statistic which, in the US would likely prompt grave warnings about the need to pursue “exit strategies”.

Spain, like the other countries within the European Union (EU), has other problems, because the nation has voluntarily decided to accede the so-called “Stability and Growth Pact” (SGP), which arbitrarily limits national government deficit spending to 3% of GDP, whilst limiting overall public debt as a percentage to GDP of 60% (even though there is no economic theory in evidence to justify these arbitrary figures). Since the inception of European Monetary Union (EMU), the conflict within the EU on how to co-ordinate economic policy on the supranational level has been recurrent. It fully illustrates the core problem at the heart of the EMU and its related Stability and Growth Pact. Politically, the interpretation of the euro zone’s stability pact is largely left in the hands of unelected bureaucrats, operating out of institutions which are devoid of any kind of democratic legitimacy.

More fundamental are the institutional flaws. The relation of member countries to the European Monetary Union (EMU) is more similar to the relation of the treasuries of member states of the United States to the Fed than it is of the US Treasury to the Fed. In the US, states have no power to create currency; neither do the countries within the EU. By the same token, purchasers of US state bonds do worry about the creditworthiness of states, and the ability of American states to run deficits depends at least in part on the perception of creditworthiness. While it is certainly true that an individual state can always fall back on US government help when required (although the recent experience of California makes that assumption less secure), it is not so clear that the individual countries in the euro zone are as fortunate.

The euro dilemma that Spain faces, then, is somewhat akin to the problems of a country like Iceland or Latvia. They operate under a system which prevents their government from spending money freely – precisely the sort of thing that the deficit terrorists in the US advocate on a regular basis (particularly those who call for constitutionally mandated balanced budgets, as exists in many state budgets).

Facing a worsening economic situation, the Spanish government has done what any reasonable fiscal authority would do and that is to expand its budget deficit. A significant proportion of the rising deficit is being driven by its automatic stabilizers, which is normal and sensible. But their impact to stabilize incomes is negated to a large degree by the SGP.

Why it’s Folly to Balance Budgets During a Recession

Spain illustrates the futility of seeking to impose balance budgets during a recession. It makes things worse. Budgets inexorably tend to deficit when economic activity slows and tax revenues collapse. If not addressed soon, this structural flaw at the heart of the European Union suggests problems ahead for the long-run viability of the euro, and certainly points to growing intra-European political tensions. (In that regard, it is interesting to note the recent comments by the Mayor of Athens in regard to Greece’s comparably adverse unemployment situation: “Germany owes us €10.5bn from the 2nd World War, they should give us that back and we can equate it all up, automatically our deficit falls to 5%…”).

The debate about public debt limits is arcane in the extreme and harks back to gold standard logic which is no longer applicable. It was always clear – by the nature of the structure of their monetary system (divorce between the fiscal and monetary sovereignty) that the system would not cope in a major economic crisis such as now, where unemployment is skyrocketing. As much as one can complain about the size and direction of the US government spending, the country at least is in a position (should it choose to do so) to exercise fiscal leadership, and the institutional capacity to implement it. But if the US imposes anything like the constraints on government spending demanded by the deficit warriors, we’ll have Spanish style levels of unemployment.

The Spanish government does not have the ability to provide fiscal leadership in their winter of recession because of the voluntary constraints they have imposed on their fiscal capacity courtesy of EMU membership. That is why almost one in five Spaniards is now unemployed, with no prospect of respite. With the degree of fiscal maneuver limited in all EU nations, growth in the euro zone depends on 1) a low enough interest rate to fuel private domestic spending (probably requiring asset bubbles, as in Spain, Irish housing markets), 2) entrepreneurial innovation, and 3) cost cutting, the last of which tends to suppress domestic demand. The net result has been a region has been left largely on a stagnant growth path since unification because it cannot run large enough current account surpluses given Asian cost structures and Asian exchange rate linkage to the US dollar (although it has tried to use relocation of production to Eastern Europe to gain an edge). The euro region basically rides on the back of global growth, which previously depended on the Anglo private sector deficit spending, which was largely sponsored by asset bubbles.

Having shut down their policy options in order to discipline themselves, they are stuck in a hard grind, which now will get even harder as fiscal retrenchment is attempted. Perhaps enough people will conclude after a decade of trying to work within a number of self-imposed policy constraints, it is time to try something else. I wonder how long the euro in its current incarnation can last? Is this really what the US wants? Because that is the ultimate implication of a policy which arbitrarily seeks to constrain government spending in the manner in which the Karl Roves, Robert Rubins and Pete Petersons of this world are currently advocating.

Getting Government Spending Right

So what is the “right” level of government spending? Obviously, we want the government spending to be done efficiently. We don’t want government spending to become inflationary. Keep in mind — the public purpose behind government doing all this is to raise an army, operate a legal system, support a legislature and executive branch of government, promote public infrastructure, promote basic research, etc. So there are quite a number of tasks that even the most conservative voters would have the government perform.

Ultimately, the ‘right amount of government spending’ is an economic and political decision that has nothing to do with government finances. The real ‘costs’ of running the government are the real goods and services it consumes; the real cost of the government using all these real goods and services is that those resources would other wise be available for the private sector. So when the government takes those real resources for its own purposes, fewer real resources are left for private sector activity. What matters is that taxes are set to balance the economy and make sure it’s not too hot or not too cold. And government spending is set at the ‘right amount’ to provide the requisite services and full employment. Getting caught up in the mythology of “financing” considerations or arbitrary self-imposed constraints with no bearing in any economic theory at all is the wrong path. That way lies Spain. Is this the future we want for the US?

Source: Spain: Deficit Terrorism in Action - Is This What We Want for U.S.?