I asked an old Macroeconomics professor of mine to comment on the current state of the economy, and clear things up for me, since most articles I have read have either a strong liberal or conservative spin to them. This is his beautifully crafted reply. Warning, economic terms incoming… you can google things that you don’t understand if you haven’t taken a Macroeconomics class.
Without further ado:
Right now we are experiencing a negative demand shock. We can tell that AD has shifted to the left because economic growth has declined as has the inflation rate. In fact for awhile, GDP growth and inflation were negative. This was the first time since the Great Depression that we experienced deflation. This has been one bad negative demand shock.
The government has two general responses available: monetary policy and fiscal policy. The Federal Reserve tried expansionary fiscal policy on a scale it has never tried before. It purchased over a trillion dollars worth of assets (US GDP is about 14 trillion), with the hope that as it replaced less liquid assets with liquid cash, it would most importantly prevent a liquidity crisis among financial institutions, and then encourage lending since the financial institutions would be flush with cash. The increased lending would in turn increase AD and bring the economy out of the recession.
The Fed was able to stabilize the financial markets, but it was not able to encourage lending. Because the financial institutions were fearful that borrowers would not be able to repay, and because potential borrowers already had large debt burdens, very little lending and borrowing took place. The Fed continued to expand the monetary base, but once interest rates on treasuries reached near zero, the Fed was powerless to do any more.
This meant that it was up to fiscal policy. The federal government did pass an approximately $0.7 trillion stimulus bill, but state and local government spending shrank by an even greater amount. So, the net overall effect of fiscal policy was contractionary, making the recession worse.
The reason why state governments contracted spending was because 49 of them are required to (approximately) balance their budgets. Since in a recession tax revenues automatically fall and transfer payments automatically increase, budget deficits tend to increase during recessions. Since these states are required to balance their budgets, they had to cut spending just when it was needed the most. (Vermont is the sole state not required to balance their budget, but obviously too small to make up for the other 49 states!)
In order to use expansionary fiscal policy, governments can lower taxes, increase transfer payments, or increase purchases. Good ways to choose purchases are those that can be spent quickly or those that increase our productive capacity. The quintessential are shovel-ready infrastructure projects. The most effective tax cuts and transfer payments are to those with the highest MPC. Unemployment benefits tend to go to people with high MPC. Tax cuts to the wealthiest tend to have low MPC’s.
This is a particularly political subject. The wealthiest will argue for tax cuts, particularly for the rich. The poorest will argue for unemployment benefits and blue-collar jobs. There are more poor than wealthy (meaning more who would benefit from Democratic proposals than Republican proposals), but the wealthy seem to be better organized.
There are economic reasons for their better organization. Small groups have lower costs of organization than large groups. Small groups have an easier time divvying up the benefits than do large groups. So, many political decisions tend to favor small groups, even when the benefits to the large groups are bigger.
Right now the politics has taken a further step. Like I said earlier, budget deficits tend to increase in recessions. It good times, a large deficit crowds out private investment, but these are not good times. (We can see that private investment is not being crowded out since the interest rates are so low.) So, Republicans see this as an opportunity to shrink the size of government and are arguing that we need spending cuts, but we need to stimulate the economy so there cannot be tax increases, even on the richest 2.5%. However, their argument is not consistent. Either tax cuts or spending increases would help the economy, but either would also increase the deficit. However, the Republicans are advocating the worst combination of trying to stimulate the economy and balance the budget, since tax cuts to the rich help the economy the least. (In fact, the tax cuts were proposed as temporary in 2001, and now politicians are fighting over whether they should expire. Also, taxes have been cut even further under Obama, primarily through the FICA tax cut. So, even with Obama’s proposed end to the temporary tax cut on the wealthiest 2.5%, overall taxes would still decline under Obama, at least since he took office. The Republicans’ argument is very tenuous.)
But the Republicans also want Obama to fail. Mitch McConnell said as much. A strategy of the Republicans seems to be not just keep taxes low for the rich, but to keep the economy down so that Obama is not re-elected. I personally would say that our democracy is not functioning as we would expect. Even some Republicans have commented that their party is no longer functioning properly. For example, Obama proposed a health care plan (rising Medicare and Medicaid costs are the biggest source of of future deficit spending) that was similar to one advocated by the Republican Mitt Romney when he was Governor of Massachusetts. But Republicans fought Obama. Obama has proposed more spending cuts than tax increases, but Republicans still fight it. Unemployment rate are about double what they normally are, and Republicans are fighting to keep the highest tax bracket go from 35% to 39%, even though tax rates are the lowest they’ve been since the early 60’s (I believe since Kennedy lowered them).
It’s not clear what a debt default could cause. We have never defaulted on our debt. We have a stellar repayment record and have the best credit in the world. We pay the lowest interest rates of anyone in the world because of our stellar repayment history. Right now, the interest rate on 3-month treasuries is 0.0507% (that is not 5%, but less than one tenth of a percent). The rate on 2-year treasuries is 0.371%. Those are extremely low rates. That also means that since the inflation rate is higher than the nominal interest rate, in real terms lenders are paying the government to borrow money. Such a deal!
The low interest rates also suggest that the markets do not think that the government will default. If they did, then they would insist on a much higher rate.
We might be tempted to look at other countries for clues to what would happen if the US defaulted, or to whether a large debt is a problem. However, the US is in a unique position. The US has the best credit record in history, and the US borrows in dollars. Many other countries that have defaulted, such as Russia, Mexico and Argentina, had borrowed in dollars, not their own currency, and that meant that when their currency devalued, it became more and more difficult to repay the dollars. Those countries would sell reserves in order to keep up the value of their currency, but currency traders soon would realize that the countries might soon run out of reserves, and therefore they would speculate the currency would soon collapse. This speculation would hasten the collapse, and the collapse would make it nearly impossible to pay back their dollar-denominated debts. This is not a problem for the US.
So, I think that the problems now are political. Because states require balanced budgets, they are enacting contractionary fiscal policy when we need expansionary. Because Republicans want Obama to fail, they are fighting his attempt to help the economy. I do, however, think that they will not go so far as to allow a default. So, I think that we will limp along at high unemployment rates, but not go into a crisis like Argentina has before.