Cut, cap and demolish

I have very little blog time today (less than usual). I had a major piece to finish today and an Op Ed to write and some PhD drafts to read and I am floating around outside my office. But the Internet has allowed most nearly anyone (in the advanced employed world) to become a publisher and an owner of a site. It is not a very discriminating vehicle for quality control and in some sense that is probably a good thing because quality is often just an ideological construct. But there are some truly bizarre sites that breathe life courtesy of the Internet. One of the most bizarre is the Cut Cap and Balance Act home page with if I didn’t know otherwise I would assume was a parody on everything that is nonsensical about conservative free market economic thinking. The problem is that the site is deadly serious and that is truly scary. Cut, Cap and Balance is the new catch-cry. It is high farce but the proposers are actual legislators and they are dealing with real people. They should just retire and watch the Thunderbirds or something. Because all I can see in the CCB is Cut, cap and demolish – where prosperity and peoples’ life chances are the demolition target.

Equally funny (not!) is the Caucus of House Conservatives home page where the CCB bill is outlined in detail. It is summarised in this Document. Hilarious – that is, I am struggling to think they could be serious.

The proposal is to:

• CUT total spending by $111 billion in FY 2012 – immediate spending cuts to reduce the deficit by half next year
• CAP total federal spending by statutory, enforceable caps to be in line with average revenues at 18% of GDP.
• BALANCE the budget via a Balanced Budget Amendment (BBA)

The BBA is further summarised as:

• Requiring the US President to “transmit to Congress a balanced budget that limits outlays to 18 percent of GDP” each fiscal year. There are some exceptions – all draconian – “2/3 of both Houses for a specific deficit for a fiscal year” – “a majority of Congress for a specific deficit for a fiscal year during a declared war” and some requirements if there isn’t a declared war but military conflict requires a deficit.
• Requires 2/3 of both Houses (the “supermajority requirement”) for any bill “that imposes a new tax or increases the statutory rate of any tax or the aggregate amount of revenue.”
• Increasing the nominal debt limit requires a supermajority.

Equipment to count the number of fairies at the end of the garden can be purchased without Congressional consent.

Was that part of the BBA? I must be getting confused. I thought I read that somewhere. More reearch is required.

Anyway, my assessment is this makes the options available to the US President broadly consistent and uniform with respect to domestic and external policy. He is allowed to wage war on all foreign enemies and he is forced to wage war on all disadvantaged Americans via unemployment and poverty and the number of war torn Americans is also almost certain to increase.

If we take some figures from the Congressional Budget Office we see that

As background, recall yesterday’s blog – Propose a solution to a non-problem and make the real problem worse – where I agreed with Simon Johnson that there were no signs in the US that private spending would jump ahead in a period of fiscal austerity nor that net exports were about to fill any spending gap. Simon Johnson also acknowledged that “immediate spending cuts would, by themselves, likely slow the economy”.

The safe assumption is that non-government spending overall will be fairly subdued over the next few years as unemployment persists, real wages are contained and confidence remains low. However, what is not usually stated but critical is that the current modest spending behaviour by the private sector in the US is still being supported by the budget deficit – both the discretionary component (actual explicit fiscal decisions) and the automatic stabiliser components (the cyclical sensitivity of revenue and spending).

It is very clear when you examine the data that the US fiscal stimulus – however ill-directed and small it was relative to the problem being faced – has provided for some growth in output and income and that is supporting the saving intentions of the private domestic sector.

Ask yourself what would the state of the economy be like if the deficit wasn’t at its current level or its current proportion of GDP. The answer – scientific as it is – much worse!

This raises the question that the CCB lobby don’t ever ask or discuss – what is a deficit and what does it do? If you spend any time reading their documents they discuss the deficit as a basic evil but not in any context of other spending aggregates.

They mention future tax burdens on our grandchildren and things like that but not much discussion is about now. When there are hints about the behaviour of other sectors the Ricardian Equivalence arguments seem to drift in – so – every one in the private sector is cashed up to hell and are just waiting to spend like crazy – like trillions crazy – as soon as they realise the US government is going to get off their future tax backs.

All the evidence says that that is a ridiculous assumption to be making in relation to the behaviour of the private sector which is heavily indebted, facing declining house prices (and negative equity) and with many families moving closer to poverty as a result of unemployment (that is, their “savings” are being or have already been exhausted by unemployment).

The reason there is a budget deficit of around 10 per cent at present when it was around 1.2 per cent prior to the crisis is because other spending sectors have dramatically cut back their outlays forcing the government net outlays into larger deficits independent of the stimulus packages. The CBO estimates the automatic stabiliser component is about 2.5 per cent of GDP (so about 25 per cent of the total budget deficit) which is more than twice what the total deficit was before the recession.

I have doubted that figure and think it is larger. Please read my blog – The financial press mostly reinforces the lies – for more discussion on this point.

The other point is that many of the discretionary fiscal stimulus choices will disappear as a result of their transitory nature.

Deficits are net spending flows in a particular period. They can be excessive and inflation would indicate that (for a given political consensus about the private/public spending mix at full employment). The latest US inflation data released by the US Bureau of Labor Statistics on July 15, 2011 for June 2011 shows that:

The Consumer Price Index for All Urban Consumers (CPI-U) decreased 0.2 percent in June on a seasonally adjusted basis.

With unemployment entrenched close to 10 per cent and long-term unemployment rising into record levels in the US and inflation falling it is very hard to say that the spending flows that define the deficit are excessive – which is quite apart from any erroneous discussions about whether they are sustainable.

If the deficit wasn’t at 10 per cent of GDP right now inflation would be falling more quickly and unemployment would be rising very quickly. More firms would be going broke and shedding labour and many more families would be defaulting on their debts.

The basic macroeconomics equation – Spending equals income. If you cut spending you cut income. If you cut income you cut spending – and then output and employment are lower.

I have examined the CCB literature as best as I can and I do not see any recognition this – as noted above – vague appeals to the American freedom to consume (they are already over-indebted and want to save) etc. I formed the opinion early in my reading of their arguments that they don’t actually want to discuss macroeconomics (which is where a budget deficit fits because it is about net spending flows) and prefer to mouth ideological statements hoping that no-one bothers to ask them difficult questions.

With the media mostly on side that is a fair assumption I suppose.

But consider the quote I included in yesterday’s blog from the IMF World Economic Outlook, October 2010:

A budget cut equal to 1 percent of GDP typically reduces domestic demand by about 1 percent and raises the unemployment rate by 0.3 percentage point.

Then assume that private spending doesn’t rise to fill the gap left by the CCP initiatives proposed for the coming year. If we take the CBO 2011-12 Budget estimates at face value we see that they project the total budget deficit in 2011 to be 9.8 per cent of GDP and the primary deficit to be 8.9 per cent of GDP. So the net interest payments is a bit above 0.9 per cent of GDP.

The projected primary deficit of $US1,255 billion is projected to be comprised on revenue of $US2,228 billion and $US3,708 billion in outlays (netting out $225 billion in net interest payments).

Now ask yourself what cutting the deficit in half in 2011 (approximately – recognising we are fudging fiscal and calendar years here because of data limitations) would mean.

Here are some rough calculations – rough because I could spend hours building a spreadsheet to reflect the text of the Cut Cap and Balance Act proposal – but haven’t the time (nor interest).

Some rough macroeconomic calculations tell you that if the total deficit in 2011 is predicted to be 9.8 per cent of GDP and the primary deficit is predicted to be at 8.3 per cent of GDP and the CBO estimate of the cyclical component (the automatic stabilisers) are 2.6 per cent of GDP then the CCP proposal to cut the “deficit” in half means a very big hack into the discretionary component. I understand from reading the proposed Bill that there are all sorts of exemptions and conditions but the scale of the cuts proposed in the coming year are incredible given the context and the role that the deficit plays.

If the cuts really were around 4.9 per cent of GDP then the IMF modelling suggests that domestic demand would fall by 4.9 per cent (that is obvious) and via an Okun-law type equation this would translate into a rise in unemployment of around 1.5 per cent. I think it would be higher than that because the IMF modelling is very (very) conservative.

But even if they are right the outcome would be horrendous for the US economy. Where would the replacement spending come from? Answer: nowhere. No credible economist – mainstream or otherwise – believes in the Ricardian tooth fairy. Only the extremists who have been proven wrong many times in the past make these sorts of claims.

What about the Balanced Budget Amendment?

Madness.

Even conservatives agree – see this Bloomberg article (July 19, 2011) – Republicans’ Debt Plan? Cut, Cap and Bluster – where the author says:

The amendment most Republicans have in mind is more stringent than previous versions on which Congress has voted … Over the past few decades federal revenue has, on average, amounted to 18 percent of gross domestic product. Spending has averaged 20 percent but is now at 24 percent … So spending would not be allowed to increase to accommodate the growing number of retirees on government assistance, or the rising cost of health care. Instead spending would be cut so that taxes could stay at their historical levels …

As a conservative I share the goal of a government that spends no more than 18 percent of GDP, and ideally spends less. But is it really wise to make putting that goal into the Constitution a condition of raising the debt ceiling?

There is a debate going on that the government members would not have the will to enforce rules that will often lead to major negative consequences. In that context, why impose such rules. Even the conservative Bloomberg writer doesn’t believe that Congress members would be able to withstand the political backlash if there was a major recession and the government was making it worse or worse still causing it.

But quite apart from that question, having a debate about how tight the straitjacket should be on the government deficit when the latter is not directly controlled by the government is madness and reflects a fundamental lack of education of what the deficit is and what it does and how it arises.

As I have noted before the budget deficit is a final outcome of two different spheres of influence – the discretionary policy choices of the government and the spending choices of the private sector. Please read my blog – Structural deficits and automatic stabilisers – for more discussion on this point.

The private spending (and saving) decisions can force a government budget into deficit contrary to any intent of government – via private spending restraint and the resulting fall in public revenue and rise in welfare spending. It is very difficult for a government to run against the private sector in this regard – they have to bear the deficit outcome that is delivered by the overall macroeconomic mix of spending.

The requirement that budget should be balanced in each year not only restricts the fiscal powers that governments would ordinarily enjoy in fiat currency regimes, but also violates an understanding of the way fiscal outcomes are effectively endogenous.

A sharp negative demand shock which causes an economic downturn will reduce tax receipts and increase benefits, automatically increasing the deficit. Reducing government expenditures in that situation to meet the rule will worsen (prolong) the recession, which is then likely to involve the country in even higher deficits.

The vicious circle of spending cuts implied is unsustainable and amounts to fiscal vandalism. In other words, fiscal policy becomes biased to pro-cyclical impacts violating any sensible ambitions that are the ambit of responsible fiscal management.

Another problem relates to the bias in the way fiscal adjustment is conceived. In particular, the Balanced Budget Act makes it very hard to increase taxes. So it is automatically assumed that discretionary actions to reduce the budget deficit will involve spending cuts rather than increasing taxes. This degree of inflexibility leaves the impression that the politicians in question are not primarily concerned about the size of the budget deficit, but covet the Balanced Budget proposal as a welcome excuse to force their ideological predilection for small government.

In other words, the ideological bias against public activity, particularly in the social security sphere, is dressed up as prudential economic management to give the crude religious zeal an air of authority and respectability.

What fiscal policy should be guided by?

A basic understanding of the way budget deficits arise can guide us here. The basic fiscal policy function should be to fill the spending gap. The only sustainable fiscal policy approach is to ensure that net government spending is sufficient to fund the net saving desires of the non-government sector at full employment.

The concept of “fiscal room” is an irrelevant concept unless we consider there are no spare real resources available. The millions of unemployed tell me that there are stacks of real resources available for deployment.

Thus when there is a positive desire to net save by the non-government sector then the government sector has to be in deficit to ensure there is enough spending left in the system to underwrite production levels consistent with full employment.

Please read my blog – Fiscal rules going mad … – for more discussion on this point.

Conclusion

Spending equals income. Unless there is a convincing case that net exports and/or private domestic spending is going to grow dramatically then the CCB lobby would only generate a sharp rise in unemployment and push the US economy back into recession.

The proposal is clearly a political ploy to extract as much out of the US President as the conservatives can.

But extracting any net spending cuts at present is lunacy. They should be fighting each other to get to the speaker’s lectern so they can outline a significant increase in the US budget deficit targetting job creation and wages growth. Then the budget deficit would start declining, unemployment would fall and their beloved debt ratio – irrelevant though it is – would start to taper off and eventually fall.

Happy Americans would salute their astute judgement at a time of crisis.

Video distraction or advertising section

During the recording of my band’s (Pressure Drop) new CD – aLive 2011 – some video footage was shot. The following video is a sample.

You can see the video on You Tube which allows you to share it via the code that You Tube provides.

That is enough for today!