The lamentable state of American political parties has become common sport amongst the chattering classes in Washington and beyond. Although one wonders whether this political dysfunction has really been such a bad thing when considering how united bipartisan “responsible” action always seems to result in yet more budget cuts. By virtue of the fact that Congress and the Obama Administration couldn’t agree on much for the past few years, America’s deficits got large enough to put a floor on demand. The transfer payments via the automatic stabilisers worked to stabilise private sector incomes and allowed a general, albeit tepid, recovery in the economy.
But since the beginning of the year, Democrats and Republicans have put aside a lot of their differences, and what has been the result? Well, first we got the deal to avert the so-called “fiscal cliff,” the upshot being tax increases (and not just on wealthy people, but via the regressive payroll tax hike) which took around .5% out of GDP. This despite the fact that the deficit as a percentage of GDP had already fallen from 10% to 7% – one of the fastest 3 year falls on record.
Since that time, it feels like we’ve been witnesses to a slow motion train wreck. We’ve had the sequester, which will suck a further 1 – 1.5% of GDP out of the economy. True, the data which has come out recently has continued to be pretty robust: the February manufacturing ISM index showed significant improvement since December. The forward-looking new orders component is better than the overall index by a decent margin. The employment index is moderate and stable. The non-manufacturing is even better. And ADP showed companies added more workers than earlier projected in February, indicating the U.S. job market will keep expanding this year. Of course all of this momentum could go out the window if and when the programmed fiscal restriction (much of which was only introduced on March 1st) continues throughout the year.
Not content to leave well enough alone, we now learn that President Obama has reportedly invited a handful of moderate GOP lawmakers to dinner on Wednesday night in a bid to reach a “grand bargain” to reduce the budget deficit. The olive branch (as it’s called in the press – more like a poisoned chalice for the US economy) comes less than a week after Congress failed to reach a deal to replace the so-called sequester, allowing $85 billion in painful, across-the-board spending cuts to begin taking effect. There isn’t, in fact, a “long-term deficit problem.” For what it’s worth, so long as interest rates stay below the growth rate, as they are, debt-to-GDP levels eventually stabilize and even decline (not that this should be a preoccupation of governments).
But if we start reintroducing cutbacks just as the US economy is beginning to show faltering signs of recovery, all of the recent gains on the budget deficit will go by the wayside. Why? Because fiscal austerity deflates economic activity, causing tax revenues to plunge and social welfare payments – unemployment insurance, welfare, food stamps – to explode. The perverse impact, then, is that deficits get larger – precisely the opposite of what the “austerian” brigade desires, but which is happening in earnest in places like Greece and Spain.
At the end of the day, deficits are a symptom of a problem, rather than the problem itself. That is, when the economy slides into a recession, tax revenues start falling as economic activity declines. Social transfer payments, particularly unemployment benefits, on the other hand, increase, again automatically, as more people lose their jobs. Calling the deficit a “national security problem” is akin to blaming the thermometer when it records the temperature of a patient suffering from the flu.
Similarly, cutting government investment at a time of still high unemployment is as futile as breaking the thermometer, rather than treating the underlying illness. Your doctor would be rightly sued for medical malpractice, if that was the he recommended. Shouldn’t we have a similar in place for economic quacks who advocate policies designed to make our deficits higher? Yet again, President Obama seems determined to snatch defeat from the jaws of victory.