The right and wrong ways to end the debt crisis

By Randall Pozdena

During the recent debate over the debt limit, President Obama advanced the notion of “shared sacrifice” to solve the budget deficit and national debt crises. This policy of modest budget cuts coupled with tax increases on high-income taxpayers failed in the debt cap negotiations. With the recent downgrade of Treasury securities by Standard & Poor’s, it is even more important that this policy be abandoned.

Significant stimulus of economic growth can only come from increasing the share of economic activity in high-productivity sectors. Using taxes to solve debt problems doubly saps growth. It diverts private resources from productive sectors to the large, low-productivity public sector. To get the growth rates we need, resources must be returned to the private sector –– not taken away and spent on projects selected by Washington.

The evidence on this point is strong, even if one ignores the obvious failure of recent stimulus spending. In 2009, Harvard economists Alesina and Ardagna examined about 90 fiscal reform efforts by major industrialized economies between 1970 and 2007. Their findings are an indictment of the use of public spending as a stimulus and the use of shared sacrifice policies in fiscal restructuring.

In the authors’ own words, “Fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases. As for fiscal adjustments, those based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases. In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions.”

The adoption in the UK of a shared-sacrifice model offers some real-time evidence. Thus far, only 8 percent of the cutbacks involve losses of civil service posts, and there is little evidence of growth stimulus. Any potential stimulus created by spending austerity is weakened by the VAT, capital gains and bank tax increases in the UK plan. As a result, in June, the International Monetary Fund lowered its forecast of UK growth by 12 percent and warned Britain that it must cut taxes rather than relax the spending austerity aspects of its package.

Our administration continues to hope that, through shared sacrifice, cuts in federal spending can be modest because economic growth and tax revenues will eliminate our debt problems. Unfortunately, our ratio of national debt to gross domestic product (GDP) now exceeds 100 percent. My research and that of Checherita and Rother of the European Central Bank suggest that we will be fighting a strong economic undertow.

The reason is that the high debt load itself causes a chilling effect on growth, as the graphic suggests. Once above a debt-to-GDP ratio of 50 to 75 percent, potential growth slows and can be insufficient, by itself, to get back on the virtuous path of higher growth and declining debt. That leaves one option: to restore the prominence of private activity by sharply reducing federal spending.

High Debt burden hampers growth


Randall Pozdena is a consulting economist in Portland, a former research officer in the Federal Reserve System and an Academic Advisor for Cascade Policy Institute, Oregon’s free market public policy research organization. The views expressed herein are his own.

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Posted by at 09:30 | Posted in Economy, Federal Budget, Tea Party, Uncategorized | Tagged , , , , | 32 Comments |Email This Post Email This Post |Print This Post Print This Post
  • Devin

    I am so glad you mentioned this!  I was just reading that 2009 harvard study just yesterday.  For anyone else interested in reading the whole thing here is a link: http://www.economics.harvard.edu/faculty/alesina/files/Large%2Bchanges%2Bin%2Bfiscal%2Bpolicy_October_2009.pdf

    • Steve Buckstein

      Thanks Devin.  I just inserted the link in the post.

  • Rupert in Springfield

    What this chart tells you is the best way to have a good economy is to stand back and let it happen. When you step in and try and make it happen is when it never will.

    The latest tack of those who follow the latter strategy seems to be to insist there is plenty of money to spend. They have become insane. Spending is what got us here. Spending even more has been shown ineffective at extrication. Insisting that there is more money to spend at this stage of the game is to take on the mantle of absolute lunacy and hope for the best.

  • 3H

    Just some food for thought: Paul Krugman

    • wnd

      Stand by: Charles Krauthhammer.

    • Rupert in Springfield

      Yep, Krugman has been trying to pull this sort of thing off for a while. Krugmans attempt to dismiss attacks on Keynesian economics by cherry picking the successes is about as valid as cherry picking the successes of tax cuts while dismissing their failures.

      Tax cuts do not always spur growth, and neither does government spending. However there are circumstances when they have. What is important is to not be a partisan hack and dismiss the reality of each approach. What is even more important is to take lessons from when those approaches have failed. Krugman, with his position on the stimulus, is famously wrong for ignoring the latter.

      Krugmans position on the stimulus is that it didn’t work because not enough money was spent. To place blame on this is absurd. Obama spent as much money as he was ever going to get realistically, and if it wasn’t going to be enough, Krugman should have been at the ramparts swinging a broken bourbon bottle to say stop. He did no such thing. That is where he loses credibility.

      Where he also loses credibility is in discounting the Japan experience in its totality and cherry picking.  That’s absurd. The lesson from the Japan 90’s experience was one thing – if you elect to spend to stimulate, you must overcome the inherent problem with spending as a solution – its slow to get the money out compared to tax cuts. That was the lesson of Japan, they trickled out the money and got very little for it.

      Every economist out there, I can think of zero exceptions, was saying that the big problem with the Obama stimulus was that it was back end loaded. Not one that I am aware of said that having most of the spending take place in 2010, and the lesser half in 2009, was a better approach than the reverse.

      By ignoring this Krugman becomes a partisan first and an economist second. By cherry picking in the Japan experience, rather than taking the lesson of get the money out fast, he confirms it.

      • 3H

        “and if it wasn’t going to be enough, Krugman should have been at the ramparts swinging a broken bourbon bottle to say stop. He did no such thing. That is where he loses credibility.”

        Actually, he was saying from the very beginning that it was not going to be enough and that it was not being done correctly.

        Simply because economic realities may have prevented Obama from actually devising a good stimulus plan does not make Krugman wrong for saying that it wasn’t enough.  He said from the very beginning that it needed to be different and larger – I don’t see any loss of credibility for that.

        http://krugman.blogs.nytimes.com/2009/01/06/stimulus-arithmetic-wonkish-but-important/

        http://krugman.blogs.nytimes.com/2009/02/07/what-the-centrists-have-wrought/

        • Rupert in Springfield

          >Actually, he was saying from the very beginning that it was not going to be enough and that it was not being done correctly.

          But he did not stand in opposition to the plan, which he should have done. Let’s face it, when your article ends in “Lets hope Im wrong” That isn’t exactly swinging a broken bourbon bottle at the gate and saying “Stop, your plan wont work”.

          >He said from the very beginning that it needed to be different and larger – I don’t see any loss of credibility for that.

          You don’t? That’s surprising.

          Look, Krugman and his supporters love to do two things, one to tout that he is an economist, and two to brag about the fact that he won a Nobel prize for that.

          Well, doesn’t Mr. Krugman have some responsibility to maybe act like an economist? I mean if someone is undertaking a plan which has no financial hope for success you don’t think a Nobel winning economist, with a syndicated column should say “The plan wont work, stop, don’t do it?”

          Every single economist out there who expressed an opinion on the stimulus timeline said the Obama plan repeated the exact same mistake of Japan in letting the money out too slowly.

          Every single one.

          I even said it here, repeatedly.

          So yes, I do think Krugman has incredible loss of credibility here. He was in a position to actually do something about this. Krugman is the leading liberal economist of our time. He is to the left now what John Kenneth Gailbraith was to the last generation.

          For Krugman to say that “I hope I am wrong” then amounts to “I told you it wouldn’t work” now is absurd.

          If he didn’t think it would work, then he had a responsibility to say “Stop, don’t spend $1T, it wont work”

          He didn’t and now he is trying to act like he did.

          • the real valley person

            You make no sense Rupert, as usual. Just because you don’t get 100% of what you want does not mean you should oppose something. Even Reagan was satisfied with 80%.

            Economic forecasting is not physics. There are a lot of variables. Krugman was looking at a set of variables, particularly the size of the private sector economic hole, which was still getting deeper while the stimulus debate was happening, and he calculated the amount of government dirt it would take to fill it. He concluded that Obama’s plan had 1/2 to 2/3 the amount of dirt needed. So he was supposed to say don’t bother then? Just leave the hole as is?    You have a peculiar mind.

            “Every single economist” did not say the same thing about the stimulus, and how you can even make such a bizarre statement is beyond me. Conservative economists wanted all of it to be tax cuts. Liberal economists wanted fewer tax cuts and more spending and direct aid to states. Libertarian economists wanted no stimulus at all. The end bill was a political compromise to get a few token Republican votes in the Senate.

            In the end, the CBO said the stimulus added 1-3 points to GDP growth over the past 2 years. Look at the GDP growth chart since the stimulus took effect and since it has wound down and ask yourself whether it had any impact or not. Or don’t. Your head might explode again.

            http://www.bea.gov/newsreleases/national/gdp/gdp_glance.htm

            Grow up dude. Stop seeing everything in black and white. Krugman’s critique was in the gray shade, as is most of life, politics, and economics.

          • 3H

            “Every single economist out there who expressed an opinion on the stimulus timeline said the Obama plan repeated the exact same mistake of Japan in letting the money out too slowly. Every single one.I even said it here, repeatedly.”

            Evidently not every economist: GOP may vote no, but economists back Obama stimulus

            So, do you have contradicting information that claims that every economist who expressed an opinion was against the Obama stimulus?

  • Bob Clark

    I favor trending down the share of government spending to total national spending (GDP), but I strongly recommend managing this aspiration against current to medium term economic conditions on the ground.  One problem with this analysis is it uses a period, 1970 to 2007, when economies were leveraging up (growing both private and public debts), and so does not include a period of abrupt de-leveraging which is just now getting underway.  Because of this de-leveraging phase there is a sharp down turn in consumer demand, resulting in high unemployment and economic slack.  Cutting federal government spending (austerity) will only excerbate this downturn in economic activity and result in even more unemployment.  The Federal Reserve monetary policy is already as easy as its going to get.  Of course, government borrowing more money will only hurt the credit worthiness of the government and offset any positive spending of these funds by government.

    But there is printing new currency by Treasury, and using these new monies to spend on projects which would ultimately boost supplies and offset some of the inflationary affects of such increase in money supply longer term.  Such expenditure might include reducing tuition costs for students earning degrees in engineering, medicene and certain other hard sciences.  Building new highway to relieve freight congestion.  I guess this requires a certain trust in goverment, but government has done such good things many times.  And afterall, our continued existence rests in part on our federal government’s military strength.

    I think taxes shouldn’t be cut anymore than they already have been (since Clinton left office); because afterall there is a point, when the “Laffer Curve” benefits fade away, and we may have already reached this point.  I wouldn’t be opposed to closing down some of the deductions like interest on a second home (Simpson Bowles recommendation); and I think it only fair the bottom half of the income distribution pay some amount towards the nation’s defense, instead of it’s current zero share.  I agree tax rates shouldn’t be raised especially in the current economic environment as it would only hurt macroeconomic demand and discourage private sector production.

    I would recommend reading Reinhart and Rogoff, “This Time It’s Different (an economic study of 800 years of soverign defaults).  Also, the graph above is only for one specific year and includes a diverse set of countries bothe emerging and developed.  We shouldn’t expect mature economies to have the same growth rates as those of emerging countries.  

    • Steve Buckstein

      Bob,  thanks for pointing to the Reinhart and Rogoff paper.  I believe they published a larger version in book form in 2009. Here is a link to their 2008 paper:
      http://www.nber.org/~wbuiter/cr1.pdf

  • Freeloader

    However you want to solve this thing be my guest, but don’t take away my rights.
    I need my extended unemployment, free health care, free food stamps, free housing, free TriMet passes, free Internet, etc.
    These are things I depend on and must continue to get for free as I am not willing to work at all.
    Why should I?
    We are Britain, but with better football teams.

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