December 8, 2010
President Obama has, on several occasions, drawn an analogy to argue for the need to cut government costs. “After all, small businesses and families are tightening their belts. Their government should, too,” he says. This instinct toward belt-tightening during bad times was one reason Obama called for a government pay freeze, and it is also evident in discussions and debate in Congress about ways to reduce the budget deficit.
Analogies between the government and the private sector are a popular means of justifying austerity, but government’s ability to print money and impose taxes invalidates many of these comparisons. Government can use its powers to smooth fluctuations in economic activity. During bad times, the government can offset lost private-sector demand with spending that increases the deficit. Reducing the deficit in a recession – Obama’s belt-tightening analogy – reinforces the decline in private sector demand instead and makes an already bad situation worse.
Making the situation even worse is the last thing we want right now. There have been a few encouraging signs in recent economic data, but the increase in the unemployment rate from 9.6 percent to 9.8 percent announced last week shows that our troubles are far from over. The question at this point is how long it will be until the unemployment rate begins to fall, and how long it will take to return to full employment once it does. It’s looking to be a long time – years not months – until full utilization of the labor force is restored.
Employment won’t begin growing robustly unless GDP begins growing more than it has, so it’s useful to ask which, if any, components of GDP – consumption, investment, government spending or net exports – is most likely to lead us out of the recession.
Consumption and investment spending are inhibited by income lost in the downturn, worries about job prospects, lost retirement and education savings that must be replaced, and uncertainties about future economic growth. Households and businesses will jump on the bandwagon once conditions improve, but they are not going to be the ones to start the wagon rolling. Net exports are a possibility, but hints of trouble under the surface in developing countries such as China and debt troubles in Europe make it unlikely that exports will grow as fast as needed.
That leaves government. In the long run, the private sector must take the lead role in promoting economic growth. However, government can help the economy emerge from the recession faster, help with unemployment, and set conditions for robust private sector growth once things get back to normal.
An analogy with the private sector – a valid one this time – is useful. Farmers face a yearly crop cycle that has a lot in common with business cycles. There is a boom period in the spring, summer, and fall when there never seem to be enough people or hours in the day to do everything that needs to be done. And there is also a down period – call it a recession – in winter.
The very best farmers are not idle during the winter. They use this time to repair equipment, expand capacity, and do other things to get ready for the next year’s planting and harvesting. In the spring, summer, and fall it is too costly to do these things because there is so much else to do, but in the winter there is lots of labor and equipment available for such tasks. This often requires farmers to take on new debt and pay it off after harvest, but farmers who take advantage of downtime to get ready for whatever the coming growing and harvest season might throw at them have an advantage over those who mostly remain idle during this time.
Boom times and recessions for entire economies are much the same. During boom times it is very costly to divert resources to construction and repair of the infrastructure necessary to promote economic growth. But during the economic winter, i.e. in recessions, when large quantities of labor, equipment, and raw materials are idle, the cost of such activities is relatively low. Governments that take advantage of this will be in a better position to compete in the global economy than governments that allow labor and other resources to sit idle waiting for things to improve. It does require an increase in the deficit, but if we follow the farmers’ lead and pay off the debt during boom times – something we’ve had trouble doing – we will be better off.
No matter what the government does, it will take longer than we’d like for the economy to reemploy its unused resources. But the government can help things along by taking advantage of the availability of low-cost labor and raw materials, rock bottom interest rates that make the cost of borrowing very low, and lots of infrastructure needs offering big benefits in transportation, environmental abatement, water and sewage systems, electrical grids, digital technology, and other areas. It is easy to find projects where the expected benefits far exceed the expected costs.
Political gridlock makes it unlikely that we can avoid leaving resources idle when there is so much that needs to be done and so many people are looking for work. Worse, deficit reduction based upon a false belt-tightening analogy that puts even more labor and resources on the sidelines is a mistake we should try to avoid.