http://www.angrybearblog.com/2010/07/professor-jamie-galbraiths-testimony-to.html
June 30, 2010
Professor Jamie Galbraith's testimony to Deficit Commission
<snip>
3. Future Deficit Projections are Generally Based on Forecasts which
Begin by Assuming Full Recovery, but this Assumption is Highly
Unrealistic.
Unlike the present deficits, expected future deficits are not usually
considered to be due to continued recession and high unemployment. To
understand how the discussion of future deficits is being framed, it is
necessary to grasp the work of the principal forecasting authority, the
Congressional Budget Office. CBO's projections proceed in two steps.
First, they wipe out the current deficits, over a very short time
horizon, by assuming a full economic recovery. Second, they create an
entirely new source of future deficits, essentially out of whole cloth.
The critical near-term assumption in the CBO baseline concerns
employment. CBO claims to expect a relatively rapid return, over five
years, to high levels of employment, and the baseline incorporates a
correspondingly high rate of real growth in the early recovery from the
great crisis. If this were to happen, then tax revenues would recover,
and ordinarily the projected deficits would disappear. This is what did
happen under full employment in the late 1990s.
But under present financial conditions this scenario of a rapid return
to high employment is highly unrealistic. It can only happen if the
credit system finances economic growth, which implies a rising level of
private (household and company) debt relative to GDP. And that clearly
is not going to happen. On the contrary, de-leveraging in the private
sector is sure to remain the rule for a long time, as mortgages and
other debts default or are paid down, and as many households remain
effectively insolvent due to their mortgage debt.
With high unemployment, high public deficits are inevitable. The only
choice is between an active deficit, incurred by putting people to work
or otherwise serving national needs -- such as providing a decent
retirement and health care to the aged -- and a passive deficit,
incurred because at high unemployment tax revenues necessarily fail to
cover public spending. Cutting public spending or raising taxes, now or
in the future, by any amount, cannot reduce a deficit due to high
unemployment. The only fiscal effect is to convert an active deficit
into a passive one -- with disastrous economic and social effects.
4. Having Cured the Deficits with an Unrealistic Forecast, CBO
Recreates them with Another, Very Different, but Equally Unrealistic
Forecast.
In the CBO models, high future deficits and rising debt relative to GDP
are expected. But the source is not a weak economy. It is a set of
assumptions describing an economy after full recovery from the present
crisis. In the CBO forecasts, big future deficits arise from a
combination of (a) rapidly rising health care costs and (b) rising
short-term interest rates, in the context of (c) a rapid return to high
employment and (d) continued low overall inflation. This combination
produces, mechanically, a very large net interest payout and a rapidly
rising public debt in relation to a slowly rising nominal GDP.
Even if CBO were right about recovery, which it is not, this projection
is internally inconsistent and wholly implausible. It isn't going to
happen. Low overall inflation (at two percent) is inconsistent with the
projected rise of short-term interest rates to nearly five percent. Why
would the central bank carry out such a policy when no threat of
inflation justifies it? But the assumed rise in interest rates drives
the projected debt-to-GDP dynamic.
Similarly, the rise in projected interest payments is inconsistent with
low nominal inflation. Interest payments rising to over 20 percent of
GDP by mid-century would constitute new federal spending similar in
scale to the mobilization for World War II. Obviously this cannot
happen with two percent inflation. And although a higher inflation rate
is undesirable, arithmetically it means a lower debt-to-GDP ratio.
Finally, rapidly rising health care costs and low overall inflation are
mutually consistent only if all prices except health care are rising at
less than that low overall inflation rate -- including energy and food
prices in a time of increasing scarcity. This too is extremely
unlikely. Either overall health care costs will decelerate (relieving
the so-called Medicare funding problem) or the overall inflation rate
will accelerate -- reducing the debt-to-GDP ratio.
In sum: the economic forecasts on which you are being asked to develop
a credible plan for reducing deficits over the medium term are a mess.
The unemployment and growth forecasts are implausibly optimistic, while
the inflation and interest rates projections are implausibly
pessimistic and mutually inconsistent.
Good policy cannot be based on bad forecasts. As a first step in your
work -- long overdue -- the Commission should require the development
of internally consistent, and factually plausible, economic forecasts
on which to base future deficit and debt projections.
5. The Only Way to Reduce Public Deficits is to Restore Private Credit.
The conclusion to draw from the above argument is that large deficits
going forward are likely to have the same source as they do right now:
stubbornly high unemployment.
The only way to reduce a deficit caused by unemployment is to reduce
unemployment. And this must be done with a substantial component of
private financing, which is to say by bank credit, if the public
deficit is going to be reduced. This is a fact of accounting. It is not
a matter of theory or ideology; it is merely a fact. The only way to
grow out of our deficit is to cure the financial crisis.
To cure the financial crisis would require two comprehensive measures.
The first is debt restructuring for the entire household sector, to
restore private borrowing power. The second is a reconstruction of the
banking system, effectively purging the toxic assets from bank balance
sheets and also reforming the bank personnel and compensation and other
practices that produced the financial crisis in the first place. To
repeat: this is the only way to generate deficit-reducing,
privately-funded growth and employment.
As a former top adviser in the Clinton White House, co-chairman Bowles
no doubt knows that privately-funded economic growth produced the boom
years of the late 1990s and the associated surplus in the federal
budget. He must also know that the practices of banks and investment
banks with which they were closely associated worked to destroy the
financial system a decade later. But I would wager that the Commission
has spent no time, so far, on a discussion of the relationship between
deficit reduction and financial reform.
To be clear: unemployment can be cured without private-sector
financing, if public deficits are large enough -- as was done during
World War II. But if the objective is to reduce public deficits, for
whatever reason, then a large contribution from private credit is
essential.
One more time: without private credit, deficit reduction plans through
fiscal austerity, now or in the future, will fail. They cannot succeed.
If at the time the cuts take effect the economy is still relying on
public expenditure to fund economic activity, then reducing expenditure
(or increasing taxes) will simply reduce GDP and the deficits will not
go away.
Further, if the finances of the private sector could be fixed, then an
austerity program would be entirely unnecessary to reduce public debt.
The entire national experience from 1946 to 1980, when public debt fell
from 121 to about 33 percent of GDP and again from 1994 to 2000, proves
this. In those years the debt-to-GDP ratio fell mainly because of
creditdriven economic growth -- certainly not because of public-sector
austerity programs. And this is why the deficits returned, in 1980-2
and in 2000, once the credit markets froze up and the private economy
entered recession.
Thus until the private financial sector is fully reformed -- or
supplemented by parallel financing institutions as was done in the New
Deal -- high deficits and a high public-debt-to-GDP ratio are
inevitable. In the limit, if there is no private financial recovery,
debt-to-GDP will converge to some steady-state value, probably near 100
percent - a normal number in some countries - and at that point the
public deficit will be the sole engine of new economic growth going
forward. Only when the private sector steps up, will the debt-to-GDP
ratio begin to decline.
For this reason, a Commission report focused on "entitlement reform"
rather than "financial reform" would be entirely beside the point.
Entitlement cuts, no matter how severe, cannot and will not achieve
deficit reduction. They cannot "meaningfully improve the long-term
fiscal outlook," as required by your charter. All they will accomplish
is to impoverish vulnerable Americans, impairing the functioning of the
private economy and the taxing capacity of the government.
6. Social Security and Medicare "Solvency" is not part of the
Commission's Mandate.
<snip>
The usual "solvency" arguments directed at the Social Security system
and at Medicare as separate entities are in any event complete
nonsense. These programs are just programs, like any others, in the
Federal Budget, and the Social Security and Medicare "systems" are thus
fully solvent so long as the Federal Government is. Further, as
explained below, under our monetary arrangements there is no "solvency"
issue for the federal government as a whole. The federal government is
"solvent" so long as U.S. banks are required to accept US. Government
checks -- which is to say so long as there is a Federal authority in
the Republic. This point has been demonstrated repeatedly in times of
stress, notably during the Civil War and World War II.
7. As a Transfer Program, Social Security is Also Irrelevant to Deficit
Economics.
Political discussions of "long-term fiscal sustainability" -- including
in the Charter for this Commission -- make an economic error when they
loosely use the word "entitlements" and suggest that supposed economic
dangers of federal deficits (for instance, rising real interest rates)
can be reduced by "entitlement reform." As a matter of economics, this
is not true.
"Government Spending" -- as any textbook will verify -- is a component
of GDP only insofar as the spending is directly on purchases of goods
and services. That alone is what economists mean by the phrase
"government spending." GDP is the final consumption of produced goods
and services, and government is one of the major consuming sectors; the
others being private business (investment) and households
(consumption).
Social Security is a transfer program. It is not a spending program. A
dollar "spent" on Social Security does not directly increase GDP. It
merely reallocates a dollar from one potential final consumer (a
taxpayer) to another (a retiree, a disabled person or a survivor). It
also reallocates resources within both communities (taxpayers and
beneficiaries). Specifically, benefits flow to the elderly and to
survivors who do not have families that might otherwise support them,
and costs are imposed on working people and other taxpayers who do not
have dependents in their own families. Both types of transfer are fair
and effective, greatly increasing security and reducing poverty --
which is why Social Security and Medicare are such successful programs.
Transfers of this kind are also indefinitely sustainable -- in fact
there can intrinsically be no problem of sustainability with transfer
programs. Apart from their effect on individual security, a true
transfer program uses (by definition) no net economic resources. The
only potential macroeconomic danger from "excessive" transfers is that
the transfer function may be badly managed, leading to excessive total
demand and to inflation. But there is no risk of this so long as the
financial crisis remains uncured. Under present conditions Social
Security and Medicare are bulwarks for stabilizing a total demand that
would otherwise be highly deficient.
Similarly, cutting Social Security benefits, in particular, merely
transfers real resources away from the elderly and toward taxpayers,
and away from the poor toward those less poor. One can favor or oppose
such a move on its own merits as social policy - but one cannot argue
that it would save real resources that are otherwise being "consumed"
by the government sector.
The conclusion to be drawn is that Social Security should in any event
be off the agenda of your Commission, as it is a transfer program and
not a program of public spending in the economic sense. In particular
it does not use capital resources and will not drive up interest rates.
This is true whether the "Social Security System" is in internal
balance or not.