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By Marshall Auerback

We should put the recovery on solid footing by increasing wages and employment, not needlessly slashing government spending.

Just as everybody seems to be understanding the full implications of the U.K. government’s approach to fiscal policy, we may be on the verge of embracing it here in the U.S. This a very negative development.

Yes, we should eliminate wasteful and unnecessary spending (we can start with a large proportion of the defense budget). But when we are experiencing a shortage of aggregate demand (the total spending, private and public, that supports employment and output), it makes no sense to introduce further cuts by implementing fiscal austerity, which will simply drain more demand from the economy.

Current proposals from both the President and Paul Ryan for serious deficit reduction involve several trillion dollars of "savings" over the next few years. I put quotes around the word "savings" because the concept is largely predicated on the idea that cutting government expenditure axiomatically creates "savings" when in fact, such "savings" could well induce a greater economic downturn and therefore increase the deficit as a percentage of GDP, as the Irish experience is now demonstrating. The president’s counter to the Ryan proposals will simply set the stage for a bidding war on fiscal austerity.

Ask your favorite economists what that does to GDP. My guess is that they’ll tell you it will shave a few more percentage points off GDP growth. And maybe a 50% increase in unemployment as the output gap skyrockets from already insanely high levels. In other words, we could well see years of flat to negative growth unless the private sector (including non-residents) spending somehow increases at least by that much. AND THE DEFICITS WILL GO HIGHER AS A RESULT!

For household consumption or business investment to fill the current output gap in private sector spending, there would need to be an increase in that sector’s debt (which is likewise measured as a drop in private sector savings). That got us into the mess we’re now in.

Borrowing to spend on houses and cars — the traditional engine of consumer growth — rising to levels sufficient to close the output gap seems highly unlikely and cannibalizes tomorrow’s growth because private debt (as opposed to public government debt) is externally constrained. Particularly when federal deficit reduction is cutting incomes and savings. We want a growth strategy that emphasizes growth in incomes, not credit.

As many of us have tried to explain at the Levy Institute conference (see here and here), there is no magic formula that maintains growth. There are three sectors that can influence it: the private domestic sector (aka households and businesses, via consumption and investment); the government sector (aka government programs, via net spending) and the external sector (aka trade with other countries, via net exports).

So in theory, could we have government and private sector surpluses if we were able to export our way out of trouble with huge trade surpluses? In large part, export-led growth has to be driven by persistent attacks on wages and employment conditions in the name of increased competitiveness. The advocates of this type of growth don’t think that it is better to increase a nation’s competitiveness by taking the high wage-high productivity route. Rather, they are into the race to the bottom strategy — drive down employee morale and wages so that unit costs fall. It is the low productivity path and will never support significant increases in the real standards of living for our citizens. So it’s not impossible, but we can’t all be exporters and, in any case, why should the US worker export his output? Shouldn’t we embrace a high wage model that allows US workers to consume their own output, as Henry Ford realized almost a century ago?

So why is this happening? Why are we drinking the hemlock? Because both sides — Democrats and Republicans — have it all dead wrong. They both tend to agree the federal deficit is too large and is a dire threat to our well-being.

In reality, the opposite is the case. Our low output/high unemployment is telling us — screaming at us — that the federal deficit is actually too small. As contrary to current conventional wisdom as it sounds, Congress should be arguing over whether they should cut taxes and/or increase spending. Right now, we need federal government spending programs to provide jobs and incomes that will restore the creditworthiness of borrowers and the profitability of for-profit firms. We need a swift and detailed investigation of financial institution balance sheets and resolution of those found to be insolvent. We need to downsize "too big to fail" financial institutions, while putting in place new regulations and supervisory practices to attenuate the tendency to produce a fragile financial system as the economy recovers. We need to investigate fraud and jail the crooks. We need a package of policies to relieve households of intolerable debt burdens. In addition, given that the current crisis was fueled in part by a housing boom, we need to find a way to deal with the oversupply of houses that is devastating for communities left with vacancies that drive down real estate values while increasing social costs. And we’ve got to rein in the money managers who seem to be dictating policy.

The next crisis will come because we mistakenly continue to believe that we could be the next Greece and face a federal funding crisis. Instead, we’re going to turn into the next UK.

Source: Federal Deficit Too Small, U.S. Congress Should Cut Taxes and Increase Spending