Beware of deficit hawks
Recently, deficit hawks have been pushing a nefarious line of argument that I need to debunk right here and right now. The line goes as follows: we need to spend government monies now to get the economy back on its feet. In a couple of years, we can signal all clear and then raise taxes on the middle class in order to reduce the deficit again, much as we did in 1993.
While I agree that deficits will need to be eliminated, this line of thinking risks a repeat of 1937-38 in the U.S. and 1997 in Japan and must be refuted.
If you look back to the Great Depression, unemployment in the United States did not hit 10% until November 1930 and things really started to unravel one year later in 1931. We hit bottom only in 1932 and 1933 with unemployment peaking at 25.6% in May 1933. It was a long hard road out of Depression from that point forward.
However, deficit hawks in the Democratic Party convinced Roosevelt to follow an anti-deficit economic policy. This induced a second sharp recession in 1937 and 1938, extended the Great Depression by another 4 years until 1941. The stock market swooned again from a Dow Jones high of 195 to as low as 97, a loss of 50%. You should note that debt to GDP stayed around 40% during this period even while Roosevelt increased spending on public works. On the other hand, Debt to GDP increased from the 20% range to the 40% during the Hoover administration. Below are the numbers on government spending as a percent of GDP.
In Japan, events followed a similar path with the economy leaving a steep recession in the early 1990s such that by 1997 the Japanese felt strong enough to start reducing deficit spending by raising taxes on the middle class. Prime Minister Morihiro Hosokawa announced a $49 billion income tax cut in April 1997 that disguised a massive sales tax rise from 3% to 7%. The result? A severe recession and stock market slump that lengthened the Japanese lost decade.
Just as in the two previous periods of asset deflation, we are dealing with massive amounts of debt and leverage combined with severe declines in standards of living for average citizens. In both previous cases, government thought we were out of the woods and raised taxes in order to return to fiscal prudence. On both occasions, the result was a severe recession and stock market meltdown.
Can we really balloon the deficit to $1 trillion and expect business as usual in 4 to 5 years given the precedents and given the low savings and high debt? This doesn’t make sense to me. Read my post “Charts of the day: U.S. macro disequilibria” to see greater detail on some of the headwinds we face.
I would normally consider myself a deficit hawk as well. However, this is not the early 1990s. The recession will be much deeper, the possibility of systemic risk much greater. And the imbalances are much larger. I think it sensible to use this period of economic weakness to get the country on the right foot. And, quite frankly, this is not a 2-years-and-you’re-done kind of process. This is going to be a decade-long struggle to restore balance and reduce debt. I am talking about 2018 and not 2012 here.
In the meantime, government needs to be thinking longer term and this means investing in infrastructure – human and capital. We need to invest in education, healthcare, roads and bridges. We need to invest in our cities and our towns so that when we we are in a healthier state we can work down the deficit spending through income gains and minimal tax increases.
So back to that question — because the Obama administration is going to be beset by parties using the immediate deficit reduction line of argument: Can we really balloon the deficit to $1 trillion and expect business as usual in 4 to 5 years given the precedents and given the low savings and high debt?
My answer is no. The U.S. economy cannot possibly work itself out of the greatest financial crisis in some 70-odd years in a mere 4 years and then expect to raise taxes on the middle class without a major recessionary relapse.
So, when you hear policy makers talking about reducing the deficit as soon as possible, what you should think is 1938 and continued depression. While all of this is still a number of years off, we need to nip this talk in the bud now before it becomes orthodoxy.