Budget Worries Hinder Ability to Fix Economy
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The Fiscal Times
June 7, 2011

The latest dreary unemployment report gives little reason to expect that an acceleration in the recovery is just around the corner. In fact, when the jobs report is combined with the many other recent data points indicating weakness in the economy, the worry is that output and employment growth could slow further in the months to come, or even head back into recession.

The Obama administration's response to the employment problem has been a case of too little, too late, and without the needed follow-up when it became clear the initial stimulus was far from sufficient to turn the economy around. The federal response did offset changes in government spending and taxes at the state and local level induced by balanced budget requirements, and neutralizing those changes was important.

For sure, the stimulus prevented an even worse collapse. But people expected more than simply offsetting negative changes at other levels of government with little net effect. They wanted to see the positive results they were promised when the package was put into place. But that would have required a much larger stimulus package delivered over a longer period of time than was politically feasible.

There are many explanations for the less than fully aggressive response, including ideological opposition to government involvement in the private sector from Libertarians and Republicans; but a big factor has been fear of an exploding public debt.

We were already running a large deficit when the recession hit. The Bush tax cuts, combined with the wars in Iraq and Afghanistan, explain much of the deterioration in the budget from the surpluses of the Clinton years. Had we made the sacrifices necessary to fund the wars instead of borrowing to pay for them, and if we had not embarked upon a budget-busting trickle down policy of tax cuts for the wealthy, the budget would have been in much better shape when the recession hit and our response could have been much more aggressive.

There are good reasons to take on debt when the economy goes into a recession, and current fears about the debt are overblown. There is no sign that financial markets are worried and we ought to be doing more. But support for borrowing at the level that is needed has been lacking among policymakers in Congress.

And it is not just Congress that’s been constrained by worries over the debt. The Fed’s ability to respond has also been affected. Some members of the Fed are very fearful of monetizing the debt and causing inflation. They see a government that is spending without the discipline to pay for it, and they’re fearful that stimulative monetary policy and the debt monetization that comes with it will further enable this irresponsible behavior and risk an outbreak of inflation. With a more responsible fiscal policy prior to the recession, these fears would have been eased, leaving the Fed more room to respond aggressively.

The ability of both monetary and fiscal policymakers to respond aggressively is important because it gives us insurance against recessions. Spending on wars and tax cuts for the wealthy that blow holes in the budget are the equivalent of a household reducing the hours it works and then paying for it by discontinuing its auto, fire, and health insurance. That’s fine as long as no wrecks, fires, or big health problems hit the household, but it’s a disaster if those problems do occur.

Unfortunately, when we reduced our insurance by blowing a big hole in the budget, we ran into a big problem – the financial sector crashed and burned, followed by a crash of the economy – and our ability to respond with monetary and fiscal policy was limited by the budget problems created during the Bush years.

What we did, in essence, was trade tax cuts for the wealthy and spending on wars for increased working class misery – higher unemployment, insufficient social service support, and a slower recovery from the recession.

The Bush tax cuts were part of a “starve the beast” strategy intended to shrink the size of government. A huge budget hole would force cuts in spending, at least in theory, but in reality it didn’t work. Government continued to expand even under Republicans – for example, consider Medicare Part D, “the most fiscally irresponsible piece of legislation since the 1960s,” – and the result was a budget in no shape to deal with a big recession.

Record high food stamps, extended unemployment insurance, and other social programs provided important help for those affected by the recession. Even so, the constraints on our ability to respond are taking their toll as evidenced by increased poverty and other measures of social well-being.

We cannot allow this to happen again. Someday another crisis will hit no matter how hard we try to prevent it, and we must not repeat the mistake of being in a position where budget worries inhibit our ability to respond.

Related Links:
Worried about U.S. Debt? (WSJ)
China to U.S.: Forget Debt Ceiling, Cut Spending (Reuters)

University of Oregon macroeconomist Mark Thoma writes primarily about monetary policy its effect on the economy. He has also worked on political business cycle models. Thoma blogs daily at Economist’s View.