Obama Faces His Own "Teachable Moment"

Nov 4, 2010Marshall Auerback

marshall-auerback-100The new Congress is likely to put extreme economic positions to the test.

The President loves teachable moments. Well, he's about to get one when the new Congress is sworn in next January. During the midterm elections, we were constantly told that businesses and households were so terrified of higher future taxes associated with budget deficits that they were not investing or spending. Our "spendthrift" government, then, was responsible for killing economic growth (even though most of the spending continued Bush's policies and kept the rich bailed out). The spending led to the constant chorus, heard endlessly as the election results poured in Tuesday night, that the "socialistic" fiscal stimulus actually undermined growth, and that fiscal restraint ("living within our means as a household does") was the key to growth.

But now it's put up or shut up time for the fiscal austerian brigade. What are they going to cut? How are those cuts going to lead us back to economic prosperity? When I hear people such as Congressman Eric Cantor discussing the need for the government to go on a diet, I wonder if he actually considers that his party's end objective, if successful, will simply transfer debt back to private households and businesses.

To have a "teachable moment," you need a teacher who's on top of his material. The President's Wall Street tutors have shown themselves to be economic quacks. They are as responsible as anybody for driving this economy into the ditch that Obama invoked so much during the midterm election campaign.

So let's try to give the President a fresh tutorial. God knows he'll need it when he is discussing this stuff with the likes of Rand Paul. When the government runs a surplus, the non-government sector has to be in deficit, and vice-versa. There are distributional possibilities between the foreign and domestic components of the non-government sector, but overall that sector's outcome is the reverse image of the government balance. This is a fundamental bookkeeping reality.

So the President can start by pointing out that when the new GOP Congress and its Tea Party allies argue that the government sector should be in surplus, this is tantamount to saying that the non-government sector should be in deficit. The fact is that US net exports today are not strong enough to simultaneously support a reduction in private debt and a public surplus while pushing growth to its full employment level. If the foreign sector is in deficit, national accounting relations mean that a government surplus will always be reflected in a private domestic deficit, which is precisely what happened during the 1990s.

It's simple. If there is a current account deficit (which we have today in the US), and both the government and private domestic sectors implement plans to reduce spending and pay down debt, there will be shortfall in aggregate demand, which will generate cuts in output and income. These income shifts drive the budget towards or into deficit and stifle the private sector plans to save. So eventually the actual balances add to zero. But neither the government, nor the domestic private sector, will be achieving their plans. Cutting government spending now means growth will slow. The automatic stabilizers will kick into gear. Tax revenues will fall further. DEFICITS WILL GO HIGHER. Consequently,  the attempt to force people to "live within their means", as our new GOP-led Congress desires, will actually create precisely the opposite effect.

Throughout the first two years of his Presidency, Obama's "negotiating strategy", if one could call it that, indicated he wasn't going to take Republicans on, but try to find common cause with the other side. Negotiation ultimately implies a willing partner. Fat chance. If the President's tactics had been used by King Solomon, the child would have been cut in half in the spirit of "bipartisan compromise".

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Enough already. The showdown moment will come soon enough. We've got the expiration of the Bush tax cuts coming up at the end of the year. The President might well extend the tax cuts permanently. Or he and his party might insist that the provision only applies for those earning less than $250,000. What if the GOP doesn't compromise? Gridlock means taxes go up in the New Year, which further drains aggregate demand.

And what about the debt ceiling? The new Congress is due to vote on raising it early next year. Although many of us have long argued that a sovereign government faces no OPERATIONAL constraint in terms of spending money, it is also clear that we have imposed many LEGAL constraints, which do create potential solvency issues for the US. America's institutional arrangements still reflect gold standard conditions, all the way through.

Consider a simple example: suppose the Treasury account hits zero and it writes yet another check. Will the check bounce? Back in the days of the gold standard, this meant there was no gold left in the vault. If the Treasury promised someone more gold, it could not deliver. The check would indeed bounce, and the central bank would be forced to raise rates in order to attract gold flows back into the country to fund future spending.

But we are no longer on a gold standard, and for the Treasury to clear its check, it must adhere to agreed debt ceilings, along with laws that mandate that the Treasury issue bonds to "fund" all government expenditures. We could easily circumvent this requirement by letting the Treasury account go into the negative (overdraft) at its "bank", the Federal Reserve. The Fed would need to let the Treasury account have a "-" in the spreadsheet cell that tracks its number, as Winterspeak has pointed out.

Currently, this is illegal. However, when the Treasury did not have sufficient funds in its deposit at the Fed in the past, it temporarily circumvented this problem by selling bonds to special depositories that are allowed to buy the bonds by crediting the Treasury's deposit. The Treasury would then transfer its deposit to the Fed before spending. This would normally result in a reserve debit from the accounts of those banks, but the Fed would allow a "float" (i.e., postpone the debit) because subsequent spending by the Treasury would restore the reserves. This expedient, however, can only work for a matter of days, because if the new Congress does not raise the debt ceiling or change the law mandating that we "fund" our expenditures via bond sales, the US Government will have decided to bounce its own checks. Its next decision, one presumes, would be to default.

That's the legal constraint. It's dumb, but it's real. It also means, for example, that around $80 billion of spending power will be withdrawn from the economy as the temporary extension of unemployment insurance expires. That might fire up the GOP's base, but it could well prove a fleeting pleasure. Consider the possibility (as Lawrence O'Donnell did Tuesday night) that the new Senator from Kentucky, Rand Paul, for example, leads a filibuster preventing the debate on allowing the government to raise the debt ceiling. How will the billionaires who have funded Tea Party candidates react when one of their own actually acts out of principle and potentially creates a new financial crisis? In the event that Congress is unable to raise the debt ceiling, it effectively forces the American government to default on its debt. Sure, the markets might take it in their stride for a few days, but after a few weeks, will they remain sanguine?

Sounds improbable? Well, re-read your history of the 1994 "Contract with America" Congress, led by then Speaker of the House Newt Gingrich. Under Gingrich's direction, the US Congress decided to default on US Government debt by refusing to raise the debt ceiling. The only reason the Government did not default was because Treasury Secretary Robert Rubin was able to make a payment from an account balance hitherto undisclosed to Congress. Just about every time the self-imposed US debt ceiling is about to be breached, this issue arises, and yet nobody ever considers the possibility that US bonds would stop being "money good". Normally there's a good reason for that: After members of Congress dutifully wring their hands and declaim the burden the Administration is placing on future generations, the debt limit is invariably increased. That could well change, given the fanaticism of some of our new Congressmen and Senators. Will Obama be in a position to do something about it? Will he explain that bond sales are a completely voluntary and self-imposed operation for any sovereign government? Probably not, especially if one is to judge from the press conference he held early yesterday morning. Deficit reduction was one of the main things he talked about. But the President better figure out something soon. His latest "teachable moment" is just around the corner.

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.

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