Thursday, February 24, 2011

A Tale of Two Narratives

There is an extreme disconnect between liberals and conservatives regarding what needs to be done to right the economy and reduce unemployment.

The usual conservative claim is that we need to cut taxes to spur growth and reduce spending to reduce the deficit in order to maintain economic security. Reducing spending is what is often referred to as "austerity measures". Basically, cutting back on government services in order to narrow the budget deficit.

The usual liberal claim is that we need to stimulate the economy through government spending in the short term by investing in infrastructure, education, and technology (President Obama's 3 pronged "Win the Future" mantra from his recent State of the Union). Though unspoken by a majority of liberal politicians, the other aspect of this is - raise taxes to narrow the revenue-expenditure gap.

For a very long time the way our government functioned was rational. Running a surplus or modest deficit (small, short term federal deficits are economically beneficial due to the economic utility of the bond market) during good times in order to pay for the costs of wars or recessions. War is self-obvious - they're expensive. But recessions are important too, because tax revenue declines (less income to tax) and demand for social services increases (unemployed seeking benefits, people dropping into poverty, etc). This made sense and everyone understood it - both left and right.

However, in the 1980s President Ronald Reagan claimed deficits didn't matter. Deficit spending by the federal government, which until that time had been modest except during war or extreme recession, ballooned into standard practice.
figured borrowed from

As you can see from this figure, other than World War II, surpluses and deficits were modest from 1945 until the early 1970s when we had our first post war recession. That golden era of capitalism, from approximately 1945 to 1973 represented the most sustained and robust economic growth in our nation's history. A rising tide lifted all ships as business owners and workers alike saw their incomes greatly outpace inflation.

When Reagan took office in 1980 we began to see much larger deficits through both his and his successor's terms. President Clinton increased revenue and reduced spending to achieve our first budgetary surpluses since the 1950s. These were squandered during a time of relative economic growth by his successor, George W. Bush, who cut taxes and went to war. An unfunded war, which contributed greatly to our real deficit, but was ignored by his administration's accounting practices. In that 8 year period our national debt increased from $5.7 trillion to $9.2 trillion. $3.5 trillion in just 8 years after accumulating $5.7 trillion in the previous 211 years. How was that even possible? And during a period of relative economic prosperity?

It's simple. He cut taxes and increased spending precipitously. Look at the blue and orange lines from the figure above. Around about 2001, tax revenue plummeted while spending continued to increase.

You're probably saying, that's all great, but how does it relate to the disparity in opinions between left and right in ways to fix our economy? Well, that brings me to the NY Times piece from two days ago, which demonstrates that stimulus, not austerity, is the path to recovery. Britain's economy has contracted since their austerity measures were announced. Germany's economy has slowed since their stimulus spending has ebbed. The American recover remains robust, because our stimulus has not yet run out.

If we allow our stimulus spending to expire, our growth will likely slow to something similar to Germany - though they have a more robust manufacturing base than we do so it's tough to draw a complete parallel. If we actually cut our federal spending, as is currently being proposed by both sides of the aisle, we risk a double-dip recession like the UK is currently experiencing. Even Goldman-Sachs is worried about the spending cuts, stating that it will likely result in a 2% reduction in expected growth in our GDP next year. 2% sounds small, but it's substantial.

The solution, of course, is not easy. President Obama's proposed 3 pronged approach to continued growth and development makes a lot of sense. This will cost money, but that money will be well worth the investment if we can improve our educational attainment, improve our infrastructure, and advance our technologies. That would have an additional benefit of providing more stimulus to our fragile economic recovery. Unfortunately, Congress appears to have no stomach for it.

Now to taxes. There is ample evidence that reducing taxes does not increase tax revenue, despite persistent claims by conservative politicians to the contrary.

The other prong of that solution is to raise taxes on the income for the wealthy, tax capital gains equitably, and end corporate tax loopholes. To make that last part clear, corporate earnings represent the single largest source of our GDP, yet corporations now pay the lowest percentage of federal revenue since at least 1950 (haven't seen data earlier than that). Conversely, personal income (wages) are now the smallest percentage of our GDP since the government began keeping track, yet personal incomes taxes remain the largest source of federal revenue. So the biggest portion of our economy contributes the least government funding while the smallest portion contributes the most.

Income inequality continues to pervade, and yet a substantial percentage of our population is oblivious to why this is an unsustainable problem. Maybe I'll try to tackle that in a future post.

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