Hell Freezes Over: Larry Summers Gets It Right, Urging Against Austerity

Larry Summers finally gets it right, warning that fiscal austerity harms the economy and pundits misdiagnose the problem.

I generally hold little truck with former Treasury Secretary Lawrence Summers. But today I have to give credit where credit is due: his article in the Financial Times, “How we can avoid stumbling into our own lost decade,” should be mandatory reading for the Obama Administration, and indeed all policy makers and mainstream economic commentators who continue to sing from the hymnal of fiscal austerity.

While US politicians (and politicians everywhere) emphasize the “costs” of continuing the sustaining of aggregate demand via higher government spending (on the spurious grounds that such spending creates the possibility of ‘national insolvency’), they ignore the fact that there are huge daily losses in foregone income, corporate tax revenues and output. These are accumulating daily as we economically chase our own tail.

The losses engendered by high unemployment will never be regained and the longer we persist with economic bloodletting, the greater will be the damage to the economy for years ahead. I can’t put it any more starkly thanProfessor Stephanie Kelton:

Our economy is growing at annual rate of just 1.8 percent. Manufacturing just grew at its slowest pace in 20 months. More than 44 million Americans – one in seven – rely on food stamps. Employers hired only 54,000 new workers in May, the lowest number in eight months. Jobless claims increased to 427,000 in the week ended June 4. The unemployment rate rose to 9.1 percent. Nearly half of all unemployed Americans have been without work for more than 6 months. About 25% of all teenagers who are looking for work are unemployed. Eight-and-a-half million Americans are underemployed – i.e. working part-time because their hours have been cut or because they can’t find full-time work. There are, on average, 4.6 unemployed people for every 1 job opening. And even if all the open positions were filled, there would still be 10.7 million people looking for work.

Yet in response to this calamity, politicians and the media argue that the current federal budget deficit is unsustainable. I have heard numerous politicians make a household analogy: “If my household continually spent more than its income year after year, it would go bankrupt. Hence, the federal government is on a path to insolvency, and by implication, the budget deficit is bankrupting the nation”. We have all managed to delude ourselves into believing that today’s global economic stagnation (or worse) is all a product of government fiscal profligacy, rather than viewing it as a case of unregulated, corrupt finance capitalism run amok.

As Larry Summers notes:

You cannot prescribe for a malady unless you diagnose it accurately and understand its causes. That the problem in a period of high unemployment, as now, is a lack of business demand for employees not any lack of desire to work is all but self-evident …

The evidence Summers cites is overwhelming (“the propensity of workers to quit jobs and the level of job openings are at near-record low; rises in non-employment have taken place among all demographic groups; rising rates of profit and falling rates of wage growth suggest employers, not workers, have the power in almost every market”). He is also correct that this is fundamentally a problem of aggregate demand or, to put it more succinctly, a lack of spending power in the economy:

[T]he problem in a period of high unemployment, as now, is a lack of business demand for employees not any lack of desire to work is all but self-evident, as shown by three points: the propensity of workers to quit jobs and the level of job openings are at near-record low; rises in non-employment have taken place among all demographic groups; rising rates of profit and falling rates of wage growth suggest employers, not workers, have the power in almost every market.

Spending creates income which supports employment growth. Shrinking a fiscal deficit is virtually synonymous with shrinking economic growth. Cuts in government spending and hikes in taxes reduce incomes and spending in the private economy. If the fiscal consolidation is ambitious enough, it can deliver an outright recession. Just look at the euro zone, which brutally illustrates the point with each successive government austerity measure.

And, as Summers notes, simply introducing supply side reforms, via cuts in corporate taxes (a lot of which aren’t paid in any case) will not solve the problem of an economy characterized by lack of demand. There is little point, for example, in offering a slew of new investment or R&D tax credits if businesses can’t sell the goods subsequently produced as a consequence of the credits. Once spending decisions are taken and acted on, the firms then find out whether they have overproduced or underproduced. If they have overproduced – that is overestimated aggregate demand – they observe an unintended build-up of inventories. That signals to firms that they were overly optimistic about the level of demand in that particular period. Or, as Summers puts it:

When demand is constraining an economy, there is little to be gained from increasing potential supply. In a recession, if more people seek to borrow less or save more there is reduced demand, hence fewer jobs. Training programmes or measures to increase work incentives for those with high and low incomes may affect who gets the jobs, but in a demand-constrained economy will not affect the total number of jobs. Measures that increase productivity and efficiency, if they do not also translate into increased demand, may actually reduce the number of people working as the level of total output remains demand-constrained. (our emphasis)

Once firms realize they have over-produced, output starts to fall. Firms lay-off workers and the loss of income starts to multiply as those workers reduce their spending elsewhere. At that point, the economy is heading for a recession.

The only way to avoid these spiraling employment losses would be for an outside intervention to occur. Yes, this intervention could well come from an expanding public deficit, or it could come from an expansion in net exports. But the latter is dependent on the policy responses of other countries (it takes two to tango), so if Asians or Europeans decide they aren’t interested in purchasing more American goods, then there is little alternative to an expanded government intervention.

For those who are motivated by a dogmatic belief in small government, it is also worth noting that a blind adherence to fiscal austerity (regardless of the economic context) actually helps to defeat that very policy purpose. There is a very strong negative association between public expenditure and the public debt, excluding the outliers of the two world wars of last century. Generally speaking, as public expenditure increases, public debt falls, and vice‐versa. That all makes sense because government spending increases GDP growth faster than the debt increases. Why, then, does the Obama Administration embrace such policy lassitude today? Clearly the President remains intimidated by the very “experts’ (“propagandists” is a more accurate term for these market fundamentalists) who comprehensively missed the last crisis.

Yes, Summers was one of those people who propagated and implemented many of the ideas which got us into our current dilemma. But in this recent article, he is spot on. I’ll go further than Summers and suggest that growth will be stagnant for years to come and the deficit reduction fetishists will remain in denial and look for scapegoats. They will say the fiscal stimulus packages eroded private sector confidence even as they contribute to the next crisis.

But the truth is simple: You do not encourage banks to lend money at high interest rates to the insolvent and you do not introduce austerity into a recession.

One wonders why this so difficult to grasp.

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.

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Posted at June 13, 2011, 5:57am

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