Memo to the President: Resist a Simpleminded Push to Cut Budget Deficits Now

A dangerous and infectious economic idea is spreading around the world. Last week, the liberal majority in the House of Representatives rejected efforts to inject a little more stimulus into the economy; and across much of Europe and Asia, presidents, prime ministers, parliaments and congresses are calling for tighter budgets. Many economies face serious problems these days; and one of the more troubling among them is the simplistic view of many public officials that their still weak economies need a strong dose of fiscal discipline. What they ought to worry about are the odds of another economic downturn and a chance that we all may face a second financial crisis. 

Here at home, we know from the most recent data that American businesses aren’t hiring new workers in any real numbers, nor are banks lending most classes of businesses much new capital.  All this tells us that the 2009 stimulus, which has just about run its course, was not enough to restore healthy, self-sustaining growth. Yet, most politicians still don’t appreciate how damaging fiscal stringency can be for an economy that remains too weak to generate decent job creation or business investment. They may have to rediscover the lesson that FDR and his top advisers learned back in 1937, when federal belt tightening sent the barely-recovering U.S. economy back into deep recession.

In a strong economy, a big dose of additional deficit spending may well crowd out private investment, push the Fed to raise interest rates, and create significant long-term costs for taxpayers who will have to finance the additional debt forever. But it’s obvious that this economy is still very far from being strong. The Fed, for example, will never raise rates under current conditions – a mistake which, as Fed Chairman Ben Bernanke has noted, was the lesson of 1930-1932. Under these conditions, additional spending for initiatives which also make sense in themselves can actually increase private investment and long-term growth, which in turn would substantially reduce the long-term financing costs of the additional debt. 

The current political passion for tight budgets, already in full play in Germany and Britain, may have been triggered by the sovereign debt crisis unfolding in Greece and, perhaps soon, across much of southern Europe. Yet, the ultimate sources of most sovereign debt crises are weak productivity and flagging competitiveness. Add an irresponsible government willing to run unsupportable deficits and loose monetary policies, instead of taking the difficult steps required to address the underlying problems, and a sovereign debt default becomes a real possibility. But the United States isn’t facing Greece’s dilemma, and neither are Germany or Britain. And the best policies to maintain the confidence of international investors even as our own national debt rises rapidly are measures to further bolster our underlying productivity and competitiveness.  That will be especially true if the European Union’s plan to address Greece’s sovereign debt problem fails – as it almost certainly will – and the ensuing chaos triggers new worldwide financial meltdown. At a minimum, the falling value of Greek bonds, along with those of Portugal, Spain, Hungary and Italy, will further slow our own recovery and growth, making premature deficit reduction even more damaging.  

Still, while the stimulus helped temper the 2008-2009 recession and hastened its end, it was never enough to restore healthy growth to an economy twisted out of shape by a historic housing bubble and then cracked open by a systemic financial meltdown. So, the administration and Congress need to do now what should have been done in 2009 to address the forces that drove the crisis. For example, Americans won’t start consuming again at the levels needed to drive jobs and investment until they stop feeling poorer, and that will still require measures to bring housing foreclosures back to normal levels and stabilize housing prices. Moreover, so long as foreclosures remain abnormally high, our banking system’s holdings of mortgage-backed securities and their derivatives will continue to deteriorate – and the continuing losses will keep banks from restoring normal business lending. The administration’s program of subsidies for banks to refinance troubled mortgages didn’t work, so we need stronger medicine. Here’s one approach:  Since the government now owns Fannie Mae and Freddie Mac, which continue to hold a decent share of the nation’s mortgages, Congress can direct them to help bring down foreclosures by renegotiating and refinancing the troubled ones in their portfolios.

Deficit anxieties also shouldn’t stop us from taking serious steps to help reboot job creation. The best course would be measures that can reduce the cost to businesses of creating those new jobs, so let’s cut in half the payroll taxes that employers pay on new employees. And since slow job creation was a serious problem for several years before the financial meltdown, there are good grounds for making this change permanent. But since the long-term trajectory of our deficits and national debt does matter, we should also take steps to pay for this change once the economy recovers. And perhaps the best way to offset the costs of lower payroll taxes for employers, two or three years from now, would be to phase in a new carbon-based energy fee, which also happens to be the most effective way to reduce the greenhouse gas emissions driving climate change.

In the meantime, the administration also can lay the groundwork to restore long-term fiscal sanity by addressing the two big forces driving large U.S. deficits even before the world’s current problems. There’s no mystery about what those forces are – sharply-rising health care costs and substantial cuts in the tax base. The political challenge is to leave the deficit alone until the economy regains its strength, while building a new national consensus for greater revenues and much stronger steps to contain health care costs.