It is somewhat surprising that the austerity debate is still going on. Theoretically, it has long since been settled. The US consumer has seen a whopping 9 trillion dollars (or 40%) wiped off of house values and hence household balance sheets. That is a rather large shock to their balance sheets, hence it is understandable that the consumer is retrenching a bit.
Indeed, The Wall Street Journal noted recently: "Rising Income is Saved, Not Spent," and a Seeking Alpha contributor asked "Where Is The U.S. Consumer?" With figures like the above $9T, it isn't a particularly hard question to answer. Add to that the millions of disappeared jobs (adding job insecurity for many more) and stagnating wages and it's entirely understandable that, as the WSJ noted, the consumer is saving more than before.
Retrenching consumers, demand shortfall threatens
They are repairing their battered balance sheets. Now, because consumers are spending less, this would normally leave a demand shortfall, which can trigger some sort of negative spiral, as one person's spending is another person's income. So somehow, the fall in consumer spending needs to be compensated, at least partially, to keep the economy from shrinking.
In normal recessions, monetary policy would achieve that. The Fed would lower interest rates; spending like business investment and consumer durables and housing is quite sensitive to interest rates. Not this time, though. Why not?
Monetary policy powerless
Record low interest rates have had hardly any effect on these normally interest-rate-sensitive categories. Households is too preoccupied with repairing balance sheets -- that is, reducing debt -- so new credit demand from them is negligible, even at these record low interest rates. Credit demand from corporations isn't very high either. Firms sitting on more than $2 trillion in cash, raking in record profits, but many industries experience overcapacity because consumer spending is so tepid.
There is simply not much of a reason to expand production capacity under these circumstances. Since monetary policy works mostly through expanding (or reducing) credit demand, it is not surprising that:
- Since credit demand is very low, interest rates are at record lows.
- Even these record low interest rates haven't generated much of an increase in credit demand.
- Hence monetary policy isn't working very well; we're in a liquidity trap.
The simple upshot is that monetary policy works by inducing people to borrow more, which is about the last thing they want to do under the present circumstances, which can be characterized as a balance sheet recession.
In order to compensate for the reduced household spending and keep the economy from spiraling downward, demand has to come from somewhere else. That's either from abroad (net exports) or from the public sector. Monetary policy could still have some effect if it manages to get the dollar down, which would lead to more US sales abroad.
However, much of the rich world experiences similar conditions (or worse) and much of the developing world is tying their currency to the US dollar. Since depreciating the dollar is clearly a zero-sum policy at the cost of trading partners, there is limited scope for doing this, and US exports matter less in economic terms than many think anyway.
Fiscal policy supercharged
So since no large fall in the external value of the dollar can be expected, that leaves fiscal policy to fill the demand gap. Luckily, the same circumstances that make monetary policy near impotent also supercharge fiscal policy:
- Since there is excess savings, interest rates are very low. The government can borrow at record low interest rates.
- Since a balance sheet recession generates its own savings (people repairing their balance sheets), the fear that these interest rates will rise any moment in response to high public deficits and debts is way overblown, as many who warned against this for years have witnessed to their considerable surprise.
- It is difficult to argue that at roughly 2% interest rates for 10 year debt, there aren't public sector works generating a higher return than the cost of capital. By most accounts, the US could do with upgrading infrastructure and education, and restore some of its former prowess in fundamental research, for instance.
There are those that see a worrying federal encroachment of the private sector, and indeed, at 25% of GDP the Federal take of the economy is somewhat larger than the last couple of decades (even if internationally, this take is a rather small percentage still, with countries out there that have a public sector twice the relative size of the US).
However, federal taxes stand at 15% of GDP, which is lower than usual and, needless to say, very low by international standards. Both the higher Federal take and the lower tax incidence don't originate from any policy changes. There aren't any new big Federal spending programs. Employment at the Federal level is actually decreasing, not increasing.
Both the high federal spending and the low federal tax intake are caused by the same factor, the poor state of the economy. Spending goes up because more people need assistance, tax intake goes down as millions of jobs have disappeared and consumer spending is poor.
So there were no big federal programs (apart from the stimulus, but that has already mostly gone), the deficit has gone up largely as a result of the state of the economy (and the bailouts also contributed). And this is good, because it dampens the effect of reduced consumer spending, hence the economy is still growing, albeit rather moderately.
What's more, the lack of policy can continue:
The Congressional Budget Office released its new budget outlook this morning, and it says what it always says: Deficits are huge, but projected to shrink dramatically in the next few years. Congress could sit back, do nothing, and deficits would fall from 7 percent of GDP to 1.5 percent of GDP.
All that panic about the deficits and debts is rather unwarranted. It has no foundation in fact whatsoever. Yes, there is a problem long-term, almost entirely caused by increasing healthcare spending. The problem is that healthcare spending automatically increases rather steeply because people get older, more new and expensive interventions continue to be developed, and the scope for productivity increases in the sector is limited.
But this is a long-term problem for which there are long-term solutions, one of which would simply be to pay more for healthcare, as that clearly matters to people's welfare. There is room for efficiency improvements, as the US system is particularly inefficient (spending nearly twice as much as a percentage of GDP compared to most other advanced nations, while not getting better results).
All this is clear and no surprise and rather uncontroversial. Yet the amount of nonsense we read on a daily basis about fiscal policy, debts and deficits is quite staggering, even from publications and authors that should know better.
Here is one example: the Bloomberg editorial team, arguing that Krugman doesn't tell the whole story about UK austerity. Krugman was pointing out that the cumulative fall in GDP in the UK has now gone on longer than even during the 1930s. So much for the belief in "expansionary austerity," according to Krugman.
Bloomberg counters that we simply don't know what would have happened if the UK hadn't embarked on austerity. This is entirely correct, although what happened in the US could serve as some kind of indication. But then Bloomberg makes an absolutely massive mistake.
It compares the UK with the likes of Greece, Spain, Portugal, France and Italy. This is simply nonsense on several levels. First, Bloomberg argues that these countries didn't attempt similar austerity as the UK, and as a result they are now in a predicament, facing huge interest rates.
Many of these countries did embark on rather savage austerity, as it happens and not quite with the results they had in mind. But even if Bloomberg would be right, it's still comparing apples and oranges. The simple truth is that by far the most important difference is that the UK has its own currency and all these other countries do not.
Being able to issue your own currency brings several important advantages, like a more or less zero default risk (money can always be printed to pay back bond holders) and the possibility to embark on large monetary stimulus and depreciating the currency. Also, as we have explained in significant detail, being a member of a half-baked monetary union produces all sorts of handicaps.
Investors can, without incurring any currency risk, move their investments elsewhere in the monetary union if they deem other places (like Germany) less risky. The same holds for bank depositors, which is why we see a rather large scale outflow of capital from the periphery to the center, hence the high interest rates on the peripheral debt. These capital flows actually create something of a self-fulfilling prophesy. This is quite unlike the situation that the UK faces, needless to say.
In fact, the whole idea of expansionary austerity is a bit of a mirage. Even the IMF has shown (here for a summary) that austerity reduces, not increases, demand, so it's contractionary. And this from an organization whose Pavlovian reaction to a crisis used to be to demand budget cuts.
Since austerity means either hiking taxes and/or reducing public spending, there is no question that demand will be reduced. The question is, does this trigger private demand to increase to more than compensate for the fall in public demand? Not likely, but it is possible when the austerity measures engender such a boost in confidence that interest rates plunge and/or there is a large fall in the value of the currency.
This happened in Ireland in the late 1980s, about the only example where austerity was indeed expansionary. But in today's world, this is extremely unlikely. There is no lack of confidence on part of investors, as the US can already borrow roughly at the rate of inflation. Interest rates are already so low, any further fall won't have any noticeable effect. That leaves a large currency depreciation, but we already discussed that above.