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Economist Fred Carstensen is a professor of economics at the University of Connecticut and executive director of the university’s Center for Economic Analysis.

H.L.: What do the June job numbers tell you — non-farm jobs down 125,000 versus up 433,000 in May, private jobs up 83,000 versus up 33,000 in May, the workweek shortening a tad, and the June jobless rate 9.5 percent down from 9.7?

F.C.: The numbers say it really is an anemic recovery. To accommodate new people coming into the workforce we need 140,000 to 150,000 new jobs just to be holding steady. The number of people who want to be working and are not working or are only able to work part-time has continued to grow. It’s a very weak recovery

And we have a harbinger of one of the major problems we’ll face over the next couple of years: layoffs in the public sector. There were 10,000 government layoffs in June, and Congress has failed to react. There is no additional funding for the states. Also, Congress has not passed additional Medicare funding for the states. They had $24 billion to help the states, and that has failed.

H.L.: Do you see unemployment at 10 percent or more in the next six months?

F.C.: No. I think people are dropping out of the workforce so rapidly that we will not see double-digit unemployment, because that rate only measures people actively looking for work. To get unemployment benefits people have to actively search for work. So when the benefits run out, they give up, and the numbers of those who would like to work grow significantly.

H.L.: Can you be more specific?

F.C.: I expect 500,000 layoffs in state and local government in the next two years, teachers, police, firemen, city engineers, municipal maintenance people, and that will translate into them not spending, and that will produce an additional million to a million and a half job losses.

Here in Connecticut, given the scale of the deficits we’re facing, I think it’s entirely possible we’ll see something on the order of 30,000 layoffs in state and municipal layoffs one year from now. That, of course, means all of that purchasing power will be taken out of the economy, and that will have a multiplier effect. If you lose 20,000 public-sector jobs you’ll lose 40,000 to 45,000 private-sector job losses.

At the University of Connecticut we anticipate a $40 million reduction in our funding of $40 million. You take that out, and then you’re talking about potentially laying off something on the order of 120 people. And we may see tenure-track junior faculty terminated. And the state has already borrowed $1 billion for the new budget year that started July 1, while federal funds will not be forthcoming, and we’ll probably be down another $200 million in addition. Then we go into the next fiscal year with a $3.4 billion deficit, which I think is optimistic. It will probably be $4 billion.

H.L.: Deficit hawks are demanding that we start cutting the deficit now and cut spending, and they even postponed a vote extending unemployment benefits. Isn’t this the kind of policy embraced by Herbert Hoover in the 1930s which caused the second wave of the Great Depression?

F.C.: Yes. It looks like a replay of the major recession of 1937 and ’38 in the middle of the Great Depression. In ’37, thinking that the economy was well on the way to recovery, the government began to run a surplus. The Federal Reserve raised the basic interest rate on bank loans, and they raised the reserve requirement for banks. Consequently, they put the economy into a very significant tailspin. It was not the Great Depression that caused people to pay attention to John Maynard Keynes. It was the depression of 1937-1938 which demonstrated the validity of his analysis. [Increased government spending raises economic activity, jobs, and spending and stabilizes the economy short-term, so that cutting the deficit in the long term is possible. Cutting spending in a recession causes severe unemployment and revives or seriously deepens a recession.]

Now we appear to be in a replay of 1937, but the economy has not recovered in any way as it did in 1937. We have a very anemic recovery with states in deep trouble and high unemployment, and the federal government is worrying about deficit issues, which are very long-term and not addressing the short-term issues of economic recovery.

Here’s the irony: By failing to really push short-term recovery on the argument that it’s too expensive, we are actually likely to increase our total long-term deficit. One of the critical ways to address the deficit is to encourage long-term growth. So we’re being penny-wise and pound-foolish. We’re in the worst economic contraction since the 1930s, and we seem not to remember those lessons.

H.L.: How can Congress do this?

F.C: For the past 30 years the American political dialogue has presumed that government does not contribute to economic growth. That is a profoundly, historically wrong perception, but it’s widely shared, and it’s attractive given the wide public misperception of the effectiveness of the bailouts and the stimulus package, which stopped us from going over the cliff, and which we should have doubled at least. And there’s a real anger toward the financial community and the banks, and a lot of people think we lost money.

H.L.: Will the deficit hawks win?

F.C.: Yes, and they won’t pay the consequences until around 2012, when the economy is still showing a lot of weakness and lots of people are unemployed. But the deficit hawks are emboldened by the European countries that recently decided to dramatically cut spending. You’ve got a 30-year legacy of attacking government, and they think it’s a politically viable position even if it’s not a good policy.

H.L.: Is there anything that can be done to counteract the effect of future cutbacks?

F.C.: In Connecticut one of the ironies is that because the state has done so little over the last 20 years to facilitate economic development, it has some arrows in its quiver. One huge arrow, actually a javelin, is a huge unused asset that could be unleashed to drive very rapid economic recovery: The major companies in Connecticut are sitting on over $1 billion in unused and unusable research and development tax credits, which the state restricted so that only small companies can use them.

If the state would permit those tax credits to be used for new capital projects, it would result in the construction of new life sciences and advanced manufacturing facilities. It would generate new employment and over 4 million square feet of new biomedical facilities, advanced manufacturing facilities and nearly 17,000 new high-quality jobs directly. Take the multiplier effect and it would produce 35,000 to 40,000 new jobs in the state. And the marvelous thing is that it would not cost the state a dime, because the companies can only capture the tax credits if they use them for investment, which would generate so much new economic activity and tax revenue that it would not only cover the cost of the tax credits; it would generate additional revenue for the state and jobs, driving economic recovery. This would trump anything any other state could offer, and it’s a completely new approach. Connecticut could lead the nation in recovery.

H.L.: Some pundits see a real threat of deflation with inflation any time soon a fantasy. Where do you see this going?

F.C.: I don’t think there’s much danger of deflation. Commodity prices are heading up, and wages are not headed up. They’re either going sideways or down some, but I don’t think the overall impact will be deflation. With the Chinese agreeing to more flexibility in their exchange rate, lots of labor unrest in China, and increasing wages, I think because Chinese production is so integral to the world economy, Chinese prices will be going up, so deflation is unlikely. If we do get deflation it will be extraordinarily damaging.

When you get deflation, and people realize it, two things happen: First, people stop buying because they wait for lower prices. That will result in a decline in purchases which will deepen the recession and drive additional price reductions. We saw it in Japan with two decades of lost economic growth.

Also, deflation means that while prices are falling, wages typically follow. But your debts don’t go down. So you have to use a larger percentage of your income to pay the debts, and you have less to spend on other things. The more you suppress demand, the more economic contraction you have, and the more people lose their jobs, and the more the deflationary pressure increases. It’s much more difficult to deal with deflation than inflation. It’s an absolute nightmare. The combination of deflation and debts is deadly for the economy.

Disclosure: No positions

Source: Fred Carstensen: Replay of 1930s Recession