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By Marshall Auerback

What is a fiscal crisis? When does deficit spending become “unsustainable”? Today, we can see net public spending rising (sharply as a percentage of GDP in some cases) as private spending has plummeted. Still, unemployment has skyrocketed. So whatever government spending has hitherto taken place has been insufficient to offset the loss of private sector output.

Here is the true nature of today’s “crisis”: Governments are unwilling to net spend at a sufficient scale to stop the increase in unemployment. That unwillingness reflects a political constraint — which is now being dressed up by some as a matter of national security or as symptomatic of “political gridlock,” as The NY Times seeks to argue (”Party Gridlock in Washington Feeds Fear of a Debt Crisis“).

Exhibit A: According to The NY Times, it is “the unwillingness of the two parties to compromise to control a national debt that is rising to dangerous heights.” Given the state of the economy, maybe we should be thankful for political gridlock, especially if it has prevented deficit terrorists like soon-to-retire Senator Evan Bayh from implementing some of his crazier ideas about cutting back government spending.

We’re always told that our debt levels have risen to “dangerous heights,” but we seem to mix up the causation. Budget deficits go up as growth slows due to the automatic countercyclical stabilizers; they don’t cause the slowdown, but merely represent it. What Senator Bayh, and others of his ilk fail to understand is that while you can cut spending, and raise taxes, you cannot eliminate deficits via legislative fiat in the absence of dissaving from some other non-government sector.

My main critique of the deficit hawks is that they (and policy makers and investors who embrace their philosophy) simplistically focus on changing one sector’s financial balance without taking into consideration the implications for other sectors. If sharp reversals of fiscal deficits are attempted, the domestic private sector’s ability to service debt will be impaired unless large current account surpluses can be achieved. That means domestic wage deflation (which will get their private sectors to financial instability straight away) or a magnificent explosion of labor productivity and product innovation, the likes of which we have no reason to expect will spontaneously arise in the near future.

Even though the US doesn’t operate under the same kinds of explicit constraints as the European Monetary Union (EMU), a fundamental misunderstanding of how our actual modern monetary system works is driving us to the same stupid conclusions and outcomes as the EU.

Here’s a better demonstration of what we are talking about, courtesy of Professor Bill Mitchell from the University of Newcastle.

It’s worth reading this piece in its entirety, but the main point we want to highlight is Mitchell’s analysis of data from the US Office of Management and Budget. He points out that in the summary for receipts and outlays from 1930 to today (along with projections to 2015), “the US government’s budget was generally in deficit of varying proportions of GDP 67 of those years (that is, 84 per cent of the time).” Mitchell also notes (as both Randy Wray and I have discussed several times before) that each time the government has tried to push its budget into surplus, a major recession followed which forced the budget via the automatic stabilizers back into deficit.

These deficits have provided support for private domestic saving over most of this period. In times of significant national crisis — the Great Depression and World War II — budget deficits as a percentage of GDP rose as high as 30%.

Now, if budget deficits were truly as injurious to national security as the many of the deficit hawks now allege, why on earth would a country want to run them during wartime, when presumably the threat to our national security is at its greatest? Taking this logic to its perverse extreme, why would one ever declare war at a time of rising budget deficits, given the extent to which they are said to imperil our national well-being? National “solvency” or “affordability” never seem to be applied consistently across the board. Only when the issue of social welfare arises, do claims of fiscal profligacy become part of the debate.

Parenthetically, it is also worth overlaying US government fiscal deficits with movements in interest rates and inflation rates and changes to US tax regimes. These can all be seen at the US Treasury’s web site. You will see that they bear no statistically significant relationship with budget deficit levels per se over this entire period. The strongest relationship that can be established is the relationship between deficits and expenditure and hence economic growth (and employment growth).

Yet almost daily, we are bombarded with assertions bordering on the theological to the effect that budgetary profligacy, escalating health care costs and an aging population will inevitably lead to a day of “fiscal reckoning.” Read Don Peck’s story in the latest Atlantic Magazine: “How a New Jobless Era will Transform America.“

The story recounts what is undoubtedly the real intergenerational war that is being set up before our eyes. Forget about future public debt service becoming a yoke around the neck of future generations. The retired and retiring baby boomers want their high nominal fixed incomes plus purchasing power preservation (if not deflation) now and until the day they die. The youth want jobs and the prospects of a life worth living. The fiscal rectitude wing is 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.

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. We have failed to adequately harness that distrust (and both President Obama and his Democrat allies are hugely culpable in this regard), which is naturally a distrust the deficit hawks can easily exploit today to satisfy their own agenda.

But at least the US has also been the common ground of populists and small “d” democratic reformers, and somehow, we have to find a way to speak to that effectively.

Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.

Source: The True Nature of Today's Deficit 'Crisis'