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Sunday, July 10, 2011

Some thoughts on the debt ceiling debate

So, it would appear that the stage is set for some significant retrenchments in federal government expenditures. It's hard to say what spending categories will see the hammer fall the hardest, but aid to state and local governments is a likely category. It's also somewhat troubling as state and local governments have already been hit quite hard by the lag effect of the recession:

In fact, it really should be little wonder that the economy has run into such turbulence of late. The retrenchment in state and local spending appears to be accelerating at a time when private sector demand is not exactly robust either. In particular, local governments have been laying off workers at a steady and alarming rate as you can see in the graph below. Some 400,000 and the rate is only accelerating now. A few items are causing this. One is the growing loss of state aids to local governments. State aids to school districts and municipalities are one of the largest expenditure items for state governments, usually comprising a plurality or even a majority of their general fund budget. They are also one of the easiest items to cut compared to corrections or medicaid, the other two huge items in a state's general fund budget. The other factor hitting them now is a squeeze on their own revenue sources, particularly those with sales and income taxes. While those sources are turning up, there is a lag effect.

State governments, too, have been laying off:

Slightly over 100,000 jobs lost in state governments since their most recent high. Furthermore, automatic pay raises have been delayed and pay has even been cut in some cases. As real incomes have stagnated or declined, so too has real expenditures by government workers.

I would like to take this time to remind people of something regarding the analogy between households and government. People often like to say that government should behave more like a household in lean times and cut back when its revenues decline. That's all well and good, but I would feel constrained to remind them of the simple fact that there is an effect there. After all, when a household cuts back to bring its costs in line so that they can service their debt burden, their standard of living tends to decline. The family's does not become wealthier. When everyone does the same thing, the total level of spending in the economy declines. The same holds true for government. When it withdraws, there will be fewer services, fewer jobs, and fewer expenditures to businesses who provide services to the government. This will cause a decline in overall spending and employment. None of this should be earth-shattering. It was all laid out in the General Theory by John Maynard Keynes.

Indeed, government should not behave as households do, with  the common household's tendency to leverage up rising incomes in the good times while slashing and burning when incomes decline in recessions. All that does is exacerbate to underlying economic cycle by strengthening the booms and deepening the busts. If, instead, the federal government tries to keep a basic underlying level of growing spending and employment (whatever is deemed politically desirable) that uses the ability to borrow to smooth out its consumption, the procyclical effects of following the typical household's pattern can be avoided.

This logically follows from another perspective, which is that most government services either do not really vary with economic conditions such as education, infrastructure repairs, and basic bureaucratic licensing and oversight functions, or they tend to become more strained in lean periods, such as with UI benefits, TANF, and Medicaid. The former group a basic baseline level of expenditures that really should remain fairly stable and not be whipped around. The latter group is vital and designed to avoid destitution due to the various spasms of the business cycle. To have either following the pattern of the business cycle is nonsensical.

Furthermore, the argument that a reduction in government expenditures and employment will benefit the private sector is highly dubious at this particular moment. If interest rates were phenomenally high due to fears of a debt default, this might make sense. The mechanism there would be that a firm deal to reduce deficits would soothe markets, reduce interest rates, and thereby increase the affordability of capital, which has numerous positive benefits. However, this condition is not currently present. That interest rates continue to be as low as they are is indicative of capital not finding many productive outlets for investment. As such, that avenue is not open to us.

Another argument would be that we could reduce taxes on the private sector if only we could get government expenditures down, which would be stimulative. Due to the magnitude of the present deficit, that is not really an option. It's also a questionable proposition that reducing taxes and government expenditures at the same time produces a net positive economic effect as most evidence appears to support the opposite conclusion, but I'll just do a little bit of hand-waving on that one for now.

Then, we turn to the argument that business confidence would be substantially improved if there was greater clarity on the long-term trend in the deficit, public expenditures, and tax rates. To be perfectly honest, there is probably just about nothing to this argument. Very few businesses cite the long-term finances of the federal government as a factor in their decision-making. "Uncertainty" can, of course, have an effect as it did to some extent in the fall of 2008 when the solvency of major financial institutions was in question. Speaking for myself, I know a pulled in a little bit when all of that was going on, though largely so that I would have more capital to deploy for the buying opportunities to come. Furthermore, the evidence that the bulk of consumers and businesses take into account their future expected tax burdens when making decisions in the present is extraordinarily weak. There might be some marginal players on the fringes of society who do, but as a mainstream proposition, I very much doubt it.

Much more likely, consumers have continued to hold back on house purchases due to persistently declining prices. I know I have made my decision not to buy a house on that very proposition, though the rate of decline has slowed enough I am starting to consider it. This persistent drag has caused consumer spending to remain very modest as well as stunting growth in spending on new houses, which in turn is depriving businesses of the revenue growth that they need to "feel confident". There are other contributors as well, such as corporations and even small businesses that had relied on a steady flow of credit who had brushes with death in late 2008 and early 2009 deleveraging their balance sheets and accumulating cash to provide more certainty in a financial crisis. Very little of this has a whole lot to do with the federal government's financial position. Furthermore, if there is a stifling effect of government spending just being there, it would stand to reason that our economic performance would be improving rather than deteriorating as state and local governments, which account for the vast bulk of government employment and direct expenditures, have retrenched.

So, what does all of that lead to? Well, the basic structure of any grand deal would hopefully take all of the empirical and theoretical argumentation against what we seem to be careening toward. Rapid reductions in federal government expenditures to quickly close the deficit would likely derail the economy, particularly when joined with substantial contractions in state and local government expenditures, which cannot be avoided due to balanced budget requirements in the states. Further, there is no avenue by which this would benefit private sector activity at the moment. As such, it might make sense to enter into a long-term package to bring expenditures in certain categories down and taxes up, but in the short run the focus should be on continued stimulus. The general agreement should be that the stimulus not be removed until such time as the economy is on a solid footing. At that point, hopefully, we can abandon any talk of adopting the common household's approach to budgeting and instead engage in true counter-cyclical fiscal policies.

If there is some moral necessity that commands us to reduce the deficit, then so be it. However, policymakers should not delude themselves into believing that we will somehow see an economic boom due to that satisfaction of some moral need to have balanced books. If they proceed under that belief, the economic outlook will become considerably dimmer. 

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