Here’s the simplest break-down of our current economic plight that you’ll find around.
We are recovering from a debt bubble that occurred (primarily) thanks to excessive housing speculation. As the household sector repairs balance sheets (by becoming savers as opposed to spenders) spending in the economy becomes insufficient to sell all the goods and services necessary to employ everyone in the economy. Ie, aggregate demand is too low so workers get fired as capitalists maximize profits via cost cuts as they protect margins.
There are two choices from a policy perspective in such an environment. We can either support the de-leveraging by running larger budget deficits through tax cuts or spending. OR, we can let the private sector implode and "heal itself." The former is akin to a man with a case of cancer who goes to the hospital for chemotherapy and suffers through months and even years of recovery and pain (but survives). The latter is akin to the man suffering from cancer who decides he doesn’t need the aid of modern medicine and decides his body will heal itself (and dies). The results have been crystal clear in nations that have enacted austerity following their credit busts. Nations like Spain and Greece are in full-blown depressions while nations like the U.S. muddle through, but continue to grow.
Richard Koo explained this a bit less succinctly in the Financial Times yesterday. He is right. I hope more Americans begin listening to him.
Japan’s attempt in 1997 to reduce its deficit by 3 per cent of GDP -- the same size as the 'fiscal cliff' now facing the US -- led to a horrendous 3 per cent drop in GDP and a 68 per cent increase in the deficit. At that time, Japan’s private sector was saving 6 per cent of GDP at near zero interest rates, just like the US private sector today. It took Japan 10 years to climb out of the hole.
Average citizens find it hard to understand why the government should not balance its budget when households and businesses must all do so. It is risky for politicians to explain but, until they make it clear that the economy will implode if everybody is saving and nobody is borrowing, public support for the necessary fiscal stimulus is likely to weaken, as seen during the past four years of the Obama administration.
The US economy is already losing forward momentum as the 2009 fiscal stimulus is allowed to expire. There is no time to waste: the government must take up the private sector’s unborrowed savings, to keep the economy from imploding and to provide income for businesses and households so they can repair their balance sheets. Fiscal consolidation should come only once the private sector has repaired its finances and returned to profit-maximising mode.