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Tuesday, June 18, 2019

Deficits and Full Employment

In an economy that has the highest growth in 20 years and the lowest unemployment in 40, there should not be a government deficit at all. In particular, there should not be a deficit equal to more than one quarter of every dollar government spends. Yet that is the case in America today. Why? The answer is not as simple as we might think. And yet, somehow it is...

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For those of us who grew up with economics textbooks full of Phillips curves and standard Keynesian business-cycle theory, the combination of a budget deficit and full employment is an oxymoron. We were told that in the growth period of a business cycle, tax revenue exceeds government spending, resulting in a budget surplus; when a recession reverses the relationship the "padding" from the budget surplus comes in handy.

Over the cycle, we were told, there would be no net increase in government debt.

You don't need to look far down Pennsylvania Avenue in Washington, DC to see that massive deficit in the federal budget. With every economic indicator telling us we have the strongest economy in at least 20 years, that standard Keynesian theory has been solidly refuted.

Does this mean we don't have to worry about the deficit? Or does it mean we cannot do anything about it?

There are practical answers to these questions, but rarely is the debt and deficit problem discussed from a systemic viewpoint. This is problematic, since the budget deficit is a blinking indicator of a systemic error in our economy. Therefore, it requires a systemic solution, which in turn requires a systemic approach to the deficit.


1. Keynesian Theory and the Business Cycle


It is often suggested that the full-employment deficit is a refutation of Keynesian economic theory in general. However, this is not the case.

Keynesian economic theory rests on a small set of postulates, all of which are well backed up in Keynes's seminal works Treatise on Probability and The General Theory of Employment, Interest and Money. The most important among those postulates is the one saying that the world is fundamentally uncertain; there is no such thing as perfect foresight.

Amazingly, this easily understood postulate has been shoved to the side by most mainstream economists and led them to producing economic analysis with almost outrageously inaccurate predictions about the world, the economy and the future. The practical meaning of this is that economists in general believe that a free-market economy is self-correcting and always revolves around a long-term path of full employment and optimal use of all resources.

That is not the case. The free-market economy is the best economic system invented by man, simply because it relies on voluntary exchange and the pursuit of gains from trade. However, to leap from there to the conclusion that a free-market economy is always self correcting and - if left alone by government - always at full employment, is to assume that imperfect men can create a perfect economic system.

For most of the time, free-market capitalism keeps the economy churning at high levels of capacity utilization. However, on occasion a virtual stampede of negative economic sentiment can drive the economy into deep recessions. When pessimism about the future enters the economy - inevitably if rarely - most people will rationally assume that it is better not to spend money today, in order to be saved to make a decision another day.* When individual decisions of austerity align into a collective trend, the economy will take a nosedive.

The free market can end even the deepest recessions; Keynes argued (General Theory) that government can play a role in pulling the economy out of depressions by providing economic activity as a light of confidence in a dark tunnel of uncertainty. The aim of this spending would be not to create permanent spending programs but for government to temporarily take the lead.

Even friends of free-market capitalism would be unwise to dismiss his theory upfront. It is eminently well formulated and his persuasive, non-academic writings about politics and economic policy in the 1920s and 1930s provide convincing anecdotal evidence of how this temporary activist fiscal policy could make a difference for the better. The problem is not theory; the problem is reality. Government as we know it is incapable of doing anything temporarily. Therefore, it is difficult to find any role for government in the economy, at least insofar as providing remedies for the business cycle.

The cycle, namely, will always exist. We will have growth periods and recessions. That is not to say, however, that the cycle is smooth and predictable as in macroeconomic textbooks; it is not. We can have very long growth periods - we did in the 1980s and 1990s and we are now in a long recovery from the Great Recession - but we can also on occasion have long recessions. It is simply futile for government to try to predict, let alone manage, the business cycle.

Specifically, the absence of predictable business cycles tells us that the old-school textbook argument about budget surpluses and deficits balancing out over the cycle, is irrelevant. Furthermore, as we will see in a moment, the kind of spending programs that government could put in place based on this cyclical theory would inevitably morph into a permanent spending problem.


2. Cyclical vs. Structural: A Conceptual Distinction


To understand how government becomes a permanent spending problem, we need to distinguish between cyclical and structural spending programs. Logically, the distinction is really very simple:

  • A cyclical spending program expands and contracts with the business cycle, either with the cycle or counter-wise to it;
  • A structural spending program is unaffected by the cyclical variations in the business cycle.

Infrastructure spending - highways, airports, power grids, etc - is a classic example of structural spending. We need to maintain all forms of infrastructure regardless of the state of the economy. That said, it has sometimes been used as a counter-cyclical form of spending, as in the humongously wasteful American Recovery and Reinvestment Act. when this happens, spending on infrastructure becomes patchy and disruptive in a way that - as we can see today - makes maintenance and capacity expansion fall out of sync with economic activity.

From a practical viewpoint, the difference between cyclical and structural spending is more complicated than the theoretical definition suggests. Programs that are often thought of as cyclical are actually structural in nature. A good example is an entitlement program aimed at evening out income differences: it is cyclical in the sense that eligibility for the program rises in recessions and falls in growth periods, but structural in the sense that it remains in place regardless of the phase of the business cycle.

Medicaid works exactly this way: more people become eligible when unemployment is high and those who have jobs make less money; yet tens of millions of Americans remain eligible even in times of strong growth in GDP and personal income. Therefore, Medicaid is a structural spending program, not a cyclical one.

Interestingly, it is difficult to actually pinpoint a fully cyclical program under any government budget. A more practical approach is to identify programs that are predominantly cyclical, such as unemployment benefits and food stamps (a.k.a., SNAP). The problem with food stamps, of course, is that they have increasingly taken on a role similar to Medicaid, though not quite to the same degree.

Again, mainstream macroeconomic theory says that government can balance its budget over a business cycle. To make that possible, government spending would have to be overwhelmingly cyclical in nature. Since it is not, we cannot rely on the business cycle to balance the budget for us. This has important policy implications that are very often overlooked or purposely ignored by politicians and economists alike.


3. The Ideological Nature of Taxes and Government Spending


Our permanent budget deficit is a symptom of structural government spending. It is theoretically possible to adjust the level of structural spending downward until the permanent level of spending is within the boundaries needed to - at least generally - avoid long-term deficits. In practice, though, this can only happen if we change the purpose of most of the spending programs in the federal budget.

Today, two thirds of the federal budget is dedicated to income redistribution in one form or another, such as education spending (which is redistributive by nature), health care, retirement income security and welfare programs like TANF-WIC-SNAP, as well as unemployment benefits. These programs, again, are largely or entirely independent of where in the business cycle the economy happens to be.

They are also ideological in nature, motivated by a desire by government to reduce differences in income and consumption - standard of living - between individual citizens. This desire translates into spending that is unrelated to the business cycle, but also into a gradual, general expansion of spending; the trajectory of government spending is slanted upward simply for ideological purposes.

A similar preference applies to the tax side of the budget. The federal personal income tax is one of the most progressive, redistributive tax codes in the world, concentrating the bulk of the tax burden to a small minority of taxpayers. Over time, this contributes to an erosion of the budget:

  • When economic growth slows down as a result of high taxes and widespread government spending, so does growth in personal income; 
  • When personal income grows more slowly, the highly concentrated tax base erodes.

This happens in economic slow motion over an extended period of time, but it is visible in macroeconomic and fiscal data. The combination of this tax system and the structural spending of the welfare state makes for a government that gradually inches up its outlays through every business cycle (in order to ideologically expand economic redistribution) while equally gradually eroding the funding source of that very same welfare state.

Our permanent budget deficit is ultimately an ideological matter. Therefore, the start of reforms to eliminate the deficit must be ideological in nature. The nature of those reforms is a matter for a separate article; for now, let us just note that:

a) we do have to worry about the budget deficit, and
b) we can reform government in such a way that the deficit goes away - it just takes a monumental ideological commitment that is currently not within reach anywhere in the American political spectrum.

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*) This is an almost-verbatim quote from Paul Davidson's Money and the Real World.

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