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Wednesday, June 1, 2011

America’s misunderstood hero: the federal deficit

This is a very interesting article. I have thought hard about the foundations of modern capitalism. Some of the arguments put forth by the GOP politicians in Congress and by the right wing pundits betray a worrying misconception of how capitalism works.

I am not an economist but I understand that you cannot austerity measures, especially cutting public spending can only hurt an economy struggling to climb out of a recession. Deficit spending is to an economy what Cardiopulmonary Resuscitation (CPR) is to an individual with cardiac arrest.
This article by David A. Levy and Srinivas Thiruvadathai carried in the Financial Times on 31 May 2011 makes the point very eloquently.

Take a scary idea that sounds reasonable, repeat it often enough, and people begin to take it as truth. Unfortunately, current beliefs about US Treasury debt and deficits are a prime example of this principle: the US is being scared into seeking exactly the wrong sort of policy.

Many opinion leaders claim: "America is on the road to becoming the next Greece or Ireland," "The deficit is destroying our children's future," or "We need to sharply cut the deficit now before it's too late."

All wrong!

In fact, the US economy needs big deficits now, and we are nowhere near too late to act. The country can safely run big federal deficits for the next several years without them leading to default, inflation, a collapsing dollar, slower economic growth or onerous taxes on our children.

Even if the government tries to sharply reduce its fiscal shortfall over the next few years, it will almost inevitably run big deficits anyway. While Washington needs to get to work on long-term fiscal reform, attempts to cut the deficit sharply in the short term will damage the economy and prove self-defeating.
The country is presently suffering from an unusual economic condition: a contained depression. The economy needs deficit spending for now to avoid another Great Depression. (Yes, a recovery from the recession is well underway, but within a longer depression—there were recoveries during the 1930s, too.)
Without large deficits, corporate profits would plunge, leading to skyrocketing unemployment and another Great Depression.
Why? For the first time since the 1930s, the private sector is in the midst of a long period of deleveraging. Balance sheets have become much too big to be supported by incomes and they must shrink for years. And that's a momentous problem.
Aggregate private sector balance sheet contraction makes it impossible for the private economy to generate profits on its own. This point isn't taught in economics 101, but it's a fact. To sustain profits (essentially, businesses' rise in wealth) the economy as a whole has to keep increasing its wealth, which is impossible if private balance sheets aren't expanding. Total assets must be increasing solidly, and liabilities must be rising to finance these increases: no debt creation, no asset creation, no wealth creation, and no profits. The last time the private sector deleveraged was in the early 1930s: wealth creation turned negative, the entire business sector suffered an operating loss and the economy crashed. In the present, milder episode, the rate of wealth creation is the weakest since the second world war.
But there is a way to support profits during private sector deleveraging. This is through very large government deficits, which pump wealth from the public sector into the private economy. Profits have roared back over the past two years because the federal government is using debt to supplement private purchasing power, boosting businesses' revenues relative to expenses.
Slashing the deficit now would cut corporate profits, causing another recession. That would trigger new financial crises since private balance sheets are still overextended. Falling tax revenues would widen the deficit all over again. There would be little, if any, deficit reduction, just more misery and public frustration.
This contained depression, during which private balance sheets shrink to healthier, sustainable levels, won't last forever, but it will persist for a number of years.
Eventually, all the deleveraging will have created circumstances for a vibrant revival of investment, credit expansion, and wealth creation. Why? Because private debt levels will be low, and the lack of financing of new investment will have left the capital stock inadequate, ageing, and obsolete. Returns on new investment will be overwhelmingly attractive.
In this age of revival, surging investment will mean increasing wealth, profits, economic growth, and government revenue. The federal deficit will narrow rapidly and the debt will shrink relative to gross domestic product, as during the years after world war two. Until then, it is far better to contain the damage of private deleveraging by tolerating federal deficits than to allow another Great Depression.
The costs and dangers of running large deficits under present circumstances have been grossly exaggerated. Most countries have relatively low scope to carry debt, but a few, including the US, have much higher capacity. Comparisons of the US with Greece and Ireland break down on many levels, such as tax-collecting capacity and control of the currency in which the debt is issued.
The present tax and spending policies in the US are hardly optimal, and over the long term changes in government programmes will need to be made. For now, people may reasonably disagree on how deficits ought to be run, but over the next several years, large deficits will remain both essential and virtually inevitable.
David A. Levy is chairman and Srinivas Thiruvadanthai is managing director and director of research at the Jerome Levy Forecasting Center LLC.
Sent from my BlackBerry® smartphone from Zain Kenya

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