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Why Even a Deal on the Budget Is Bad for the American Economy

Outcomes range from slowdown to outright recession. And it's all totally unnecessary.

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Looking at the latest US data, business sentiment and capital spending have been eroding, and given the lagged impact of capital expenditure, that trend looks set to continue for the next few months. Against that, a number of consumer sentiment indicators remain upbeat and housing looks like it is in a firmly established uptrend, after a 5 year bear market.  In fact, the existing home inventory to sales ratio is as low as it ever gets, and that is with still very depressed sales. If sales pick up further, given low inventories and with new housing starts still below the replacement rate, home prices could lurch forward.

That said, the markets have been fairly upbeat given the rising perception of a deal to avert the US falling off the ‘fiscal cliff’. But even a deal that drains, say, 1-1.5% of GDP will have negative consequences for the US economy.  Bear in mind that the U.S. still has a very high ratio of private debt to GDP. Therefore any such fiscal restriction as contemplated by the two parties may result in a significantly lower economic growth rate than the average 3% rate of the last five quarters (which is what the revised economic data of the past few quarters will eventually show).

Of course, if there is no compromise, the impact could be calamitous.  The IMF projects as much as a 4% decline in GDP if there is a full fiscal cliff. In 1936-37 there was a fiscal cliff of almost 6% of GDP. It was followed by a 36% non annualized decline in industrial production in a mere eight months in late 1937/early 1938. More recently, all of the European countries fiscal restriction has had a more negative impact on GDP than had initially been forecast.

So the range of likely outcomes ranges from slowdown to outright recession and the silly thing is that it is all so unnecessary.  Social Security, Medicare and Medicaid impose no real burdens, even with a rising proportion of ageing baby boomers.  In fact, one could plausibly make the case that an aging society could help to generate favorable conditions for achieving sustained high employment with high productivity growth. As the number of aged rises relative to the number of potential workers, what is required is to put unemployed labor to work to produce output needed by seniors. Providing social security benefits to retirees will generate the necessary effective demand to direct labor to producing this output. Just as rapid growth of effective demand during the Clinton boom allowed sustained growth of the employment rate, even as productivity growth rose nearer to United States long-term historical averages, tomorrow’s retirees can provide the necessary demand to allow the United States to operate near to full employment with rising labor productivity—a “virtuous combination” of the high productivity growth model followed by Europe and Japan from 1970–95 and the high employment model followed by the United States during the 1960s, as well as during the Clinton boom.

Here’s what most members of Congress (and, indeed, the media and the public) fail to appreciate:  Policy formation must distinguish between financial provisioning and real provisioning for the future; only the latter can prepare society as a whole for coming challenges. While individuals can, and should, save financial assets for their individual retirements, society cannot prepare for waves of future retirees by accumulating financial trust funds. Rather, society prepares for aging by investing to increase future real productivity.  Unfortunately, no such discussions are taking place, which is likely to lead to a bad to horrific policy outcome.

They are transfers in current time. They meet today’s commitments to seniors, survivors, dependents, the disabled and the ill – commitments they have earned through work – providing them with income and services at the expense of others also currently alive.  This any community can always do, to the full extent of its will and resources.