Marshall Auerback answers a new cry from the deficit hawks.

We've persistently taken the view that there is no economic doctrine, no magic number, which would imply a firm external constraint as far as public spending goes, when dealing with a sovereign government issuing debt its own floating rate, non-convertible currency. At some point, we may indeed have a resource constraint, or an inflation constraint, but not a national solvency issue. Yet the hysteria surrounding fiscal policy has moved from the realm of rational debate and metamorphosed into a matter of national theology. Hardly a day goes by, it seems, where groups such as the Concord Coalition or the Peter G. Peterson Foundation do not bring us the message that we are all doomed unless we do something drastic to cut back our mounting federal debt.

A new book by former IMF economist by Kenneth Rogoff and Professor of Economics (and Research Associate at the National Bureau of Economic Research) Carmen Reinhart -- This Time It's Different; Eight Centuries of Financial Folly -- has given greater academic legitimacy to the prevailing deficit hysteria. The authors purport to show that once the gross debt to GDP ratio crosses the threshold of 90%, economic growth slows dramatically. President Obama's proposed budget will soon cross that line, so the cries of the deficit hawks have intensified.

Although the historical data which Rogoff and Reinhart amass -- 8 centuries and all -- sound very impressive, it is hard to see what sort of relevance a country operating under, say, an 18th century gold standard, has in regard to a country operating under a 21st century fiat currency system.

A sovereign government is never hostage to the dictates of financial capital because it no longer faces the external constraint that was always present under a gold standard regime. A nation that adopts its own floating rate currency can always afford to put unemployed domestic resources to work. Its government may issue liabilities denominated in its own currency (for interest rate maintenance reasons or to offer its savers an interest-bearing alternative to cash), and will service any debt it issues in its own currency. Whether its debt is held internally or externally, it faces neither insolvency risk, nor "structural" growth shortfalls which Rogoff/Reinhart allege when public debt levels get too high.

Nor does it make sense to lump together private and public debt, as Rogoff and Reinhart do in the book. A failure to distinguish sovereign government debt from the debt of non-sovereign governments, households, and firms calls into question the relevance of the Reinhart and Rogoff study at least as far as it applies to countries, such as the US with non-convertible currencies and flexible exchange rates. Lumping together government and private debt is meaningless and simply heightens the bogus hysteria surrounding government fiscal policy activism. Government debt is a net private asset, while private debts must net to zero. Private saving, however accomplished, increases the future consumption possibilities for the household sector at the expense of current consumption. Saving is foregone consumption which in normal times (barring huge financial crashes) will enhance future consumption.

In this context, because the household sector is revenue-constrained, it has to sacrifice consumption possibilities now to improve them later. It can increase consumption now beyond income via increasing its indebtedness or selling assets (past saving) but the budget constraint has to be obeyed at all times. But, of-course, this sort of reasoning doesn't apply to the government. A budget surplus does not create a cache of money that can be spent later. Government spends by crediting a reserve account. That balance doesn't "come from anywhere", as, for example, gold coins would have had to come from somewhere. By the same token payments to government (such as via taxation) reduce reserve balances. Those payments do not "go anywhere" but are merely accounted for. A budget surplus exists only because private income or wealth is reduced, NOT because the taxes per se fund government spending directly (which would represent a true constraint).

Consequently, it makes no sense to add together the US federal government's debt and the US private sector's debt. It is in this regard that the Clinton budget SURPLUSES had such a deleterious impact on the US non-government sector in the late 1990s: Government surpluses squeezed the liquidity of the private sector in the late 1990s, which forced greater reliance on PRIVATE debt, creating the foundations for much of today's economic fragility. If the US government had run sufficient budget deficits (which it could always have done because the government faced no external funding constraint) to finance the desire to save for the non-government sector overall, then the spending patterns would have been different (more public goods, less private goods) and the non-government sector would not have been forced into as much indebtedness.

Note also that we need to distinguish between debt that is denominated in domestic currency versus that which is denominated in foreign currency-again a distinction that is not always clear in the Reinhart and Rogoff book. It's like the difference between, for example, Japan and Argentina. In the case of the latter, the currency board arrangement effectively hamstrung monetary and fiscal policy. The central bank could only issue pesos if they were backed by US dollars. So dollars had to be earned through net exports which would then allow the domestic policy to expand. When exports crashed, the funding mechanism became untenable. By contrast, Japan has continued to issue debt denominated in its own currency and cannot therefore be subject to default risk; and as it represents a nongovernment sector's net financial wealth because of the income transfer to the non-government sector, it cannot be the cause of low growth.

It may well be the case that a government that operates a pegged currency regime, or taps the markets for substantial quantities of foreign debt to finance growth, will encounter precisely the problems articulated by Rogoff and Reinhart. Reaching a limit of 90% debt to GDP might well represent a danger area and consign these countries to subpar growth for many years. But for countries like the US, Japan, Canada or Australia, which have little or on foreign currency public debt, and adopt a free-floating, non-convertible currency regime, the Rogoff/Reinhart analysis has virtually no relevance. It should not be used as a stick with which to beat back the governments that want to deploy fiscal policy to embrace full employment policies.

Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.

Roosevelt historian David Woolner shines a light on today's issues with lessons from the past.

While most economists would agree that it is important for the Obama administration to work toward bringing the long-term deficit under control, a look at the past reinforces the notion that in the short term what we need now is more stimulus, even if this means increasing the current government deficit.

FDR's initial response to the Great Depression provides an interesting case in point, for Roosevelt came into office as something of a fiscal conservative. In keeping with the fiscal orthodoxy of the time, he called for a balanced budget during his campaign, was reluctant to deficit spend once in office, and even pressed for the successful passage of the 1933 Economy Act as one of his first major pieces of legislation-an act which cut federal spending by nearly 250 million dollars during the first months of his administration.

The unprecedented nature of the economic crisis facing the nation, however, soon led the President to seek additional expenditures in support of recovery programs like the Civilian Conservation Corps (CCC), which taken together soon outstripped any reductions achieved in the Economy Act. Still, FDR's desire to avoid excessive deficits and to work towards a balanced budget remained. As a consequence, the initial New Deal efforts to stimulate the economy were not as aggressive as many economists now feel they should have been. This argument becomes even more compelling when one takes into consideration the fact that much of the deficit-as is the case today-was due to the fall off in tax revenue that came with the down turn in the economy. In fact, when we factor in the tax increases that FDR instigated as a means to keep the deficit somewhat under control, we see that the Roosevelt Administration's fiscal polices prior to 1935 were not all that different from those pursued by Hoover between 1929 and 1931.

Further evidence of FDR's inherent fiscal conservatism can be seen in his decision to cut federal spending at the start of his second term-a move which resulted in the so called "Roosevelt recession" of 1937-38 and which led to the first increase in the unemployment rate since his assumption of office in 1933. Stunned by this unfortunate turn of events, FDR began to heed the advice of those who advocated the economic policies of John Maynard Keynes. In 1938, therefore, the President would submit a budget that called for an increase in federal spending but without any concomitant increase in federal taxes. The resulting deficit, the President argued, was necessary to enhance "the purchasing power of the nation" so as to expand the economy-and the tax revenues that would flow from it-and reduce unemployment.

FDR's embrace of Keynes's economic theories worked. Unemployment fell and would continue to fall as the federal government continued to deficit spend in response to the threats posed to the nation by the outbreak of the Second World War in 1939. By 1945, the nation had achieved an unprecedented level of economic expansion and unemployment was non-existent.

The experience gained during the dark days of the 1930s and 40s rendered the fiscal orthodoxy of pursuing a balanced budget in response to an economic crisis obsolete. In its place, governments came to accept that sometimes deficits were necessary; that the first responsibility of the state was not to shore up capital markets, but to protect and create jobs-in other words, to place Main Street before Wall Street.

David Woolner is a Senior Fellow and Hyde Park Resident Historian for the Roosevelt Institute.

Marshall Auerback breaks down Obama's address, finding confusion on fiscal policy and not enough on job creation.

If nothing else, it's clear (as one wag wrote this morning) that the state of Obama's rhetoric is strong.

The President almost always gives a good speech, but it's the follow-through that is generally problematic. And the speech itself sends mixed messages about what Mr. Obama views as his "achievements" and his priorities moving forward. For all of the talk about more jobs and tax cuts, the speech also made it clear there has been a shift to 'fiscal responsibility' with plans to pay back the 2 trillion in new debt, all well down the road (3 year spending freeze starting in 2011). The job initiatives announced were minor and there appears to be no additional fiscal relaxation of consequence apart from promises of a new jobs' bill, the effect of which could be blunted if the President aims for "fiscal neutrality".

A State of the Union address is always a good place for an incumbent President to set out his priorities, and in that regard, Obama's speech is most revealing. He rightly argues that everything "begins with our economy" and then curiously emphasizes that "our most urgent task upon taking office was to shore up the same banks that helped cause this crisis."

No, Mr. President. Your most urgent task upon taking office was to shore up employment. Over the past year it has become obvious that the policy to shore up the banks has been a dismal failure in this regard. It has done nothing to pull the economy out of its deepest slump since the late 1970s. The single most important thing Washington can do to help the vast majority of American citizens who do not work on Wall Street is to create jobs -- tens of millions of them.

The President was right about one thing: "If there's one thing that has unified Democrats and Republicans, it's that we all hated the bank bailout. I hated it. You hated it. It was about as popular as a root canal."

But at least a properly executed root canal solves the problem once and for all. The President and Congress have administered the economic equivalent of pain killers, without addressing the underlying problems in our financial sector. If we're going to undergo root canal, then let's fix the damaged nerve and prevent a recurrence of the problem. Tens of trillions of dollars have been committed to deeply insolvent institutions (the extent of which we still do not understand due to persistent stonewalling from the Treasury and Federal Reserve). These institutions continue to pay out massive bonuses to their staff on the basis of fraudulent accounting. And many of these institutions are still engaging in activities which continue to worsen household balances in order to maximize their own profitability. Households and non-financial institutions have hitherto received very limited assistance. If this is how the President measures success, God help us when we have failure.

Obama observed that "if we had allowed the meltdown of the financial system, unemployment might be double what it is today. More businesses would certainly have closed. More homes would have surely been lost." All true, but there was little value to be gained by preserving what are fundamentally insolvent institutions. The President could have done something politically popular which would have resonated with the public by shutting down zombie banks, and used fiscal policy to promote employment via a Job Guarantee program. That would be both smart economics and politically popular. The two are not always mutually exclusive, but this administration curiously appears to conflate unpopularity with "responsibility". This is what happens when you take your advice from a bunch of failed Rubinite retreads.

Again, the references to the banks reflect profound conceptual confusion at the heart of the President's financial reforms: "A strong, healthy financial market makes it possible for businesses to access credit and create new jobs. It channels the savings of families into investments that raise incomes." To repeat, credit is not a "flow" which one can access. Credit is a two-way contract between lender and borrower. The only thing that constrains the bank loan desks from expanding credit is a lack of creditworthy applicants, which can originate from the supply side if banks adopt pessimistic assessments or the demand side if credit-worthy customers are loathe to take out additional loans. The President would be more accurate in suggesting that a strong economy makes it possible for businesses to create new jobs, thereby creating a healthy financial market which facilitates access to credit.

Yes, President is correct to argue that the markets may well have stabilized...for now...but personal balance sheets have not. How long can the former be sustained in the absence of the latter not improving?

And reiterating his proposed fee on the biggest banks might play to the peanut gallery, but the real purpose is not to recover the money spent on TARP, but to change the structure of finance, particularly in the capital markets, once and for all. The President still displays an incoherent approach to financial reform and implicit beliefs in government budget constraints.

For all of the talk about tax cuts ("Let me repeat: we cut taxes. We cut taxes for 95% of working families."), what really stands out is the President's fiscal timidity. This represents the cut for 95% of working families that he promised on the campaign. It equated to about $8 per week, on average, for workers. This despite the fact that the President himself seems to recognize at one level that fiscal policy really does work:

Because of the steps we took, there are about two million Americans working right now who would otherwise be unemployed. 200,000 work in construction and clean energy. 300,000 are teachers and other education workers. Tens of thousands are cops, firefighters, correctional officers, and first responders. And we are on track to add another one and a half million jobs to this total by the end of the year.

Surprise, surprise! Fiscal policy works! And if the President had implemented a national payroll tax holiday and introduced revenue sharing for the states, he could have trumpeted even greater economic achievements. Why muddle the message with talks of spending freezes and support for misconceived "bipartisan commissions" to discuss ways of reducing "runaway government spending" when unemployment has shown little sign of stabilizing, let alone coming down? The true engine of job creation in this country will always be America's businesses, as the President recognizes, but he also notes that "government can create the conditions necessary for businesses to expand and hire more workers."  We have a mixed economy, which is why the President should not capitulate to the conservative lobbies now engaged in a renewed push for fiscal austerity even though the labor markets are disaster zones. History has a habit of repeating itself. The US government did exactly this in 1937 and the unemployment worsened. Japan did it in 1997 with the same outcome.

I could go on. It would have been interesting to hear the President explain how we would succeed in Afghanistan when both the British and Russians had comprehensively failed, but Obama clearly could only achieve so much in the space of an hour. Bowing to the conservative calls for "fiscal consolidation" at a time when unemployment is still very high and will continue to exert a massive deflationary force on the overall economy is the best way to ensure a double-dip recession occurs. Trumpeting the perpetuation of a failed banking system hardly strikes us as an achievement.

There were moments when the President really did appear to understand what it takes to make the state of the union stronger. Unfortunately, those moments were few and far between. Let's hope for once the muddled message does not reflect the reality.

Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.

Speaking of President Obama, Karl Rove writes, "After a year of living in his fiscal fantasy world, Americans realize they have a record deficit-setting, budget-busting spender on their hands."  Well, given his history with former President Bush, it certainly takes one to know one. But it is hard to understand how the concept of "budget busting" applies to a government which, as a sovereign issuer of its own currency, can always create dollars to spend. There is, in other words, no budget to "bust". A national "budget" is merely an account of national spending priorities, and does not represent an external constraint in the manner of a household budget.

A Deficit Spending Limit Disaster

What do commentators such as Mr. Rove really think would have happened if there had been tight fiscal rules in place preventing any (or only some) discretionary response in net spending? Consider a real world example. In December, Spanish unemployment rose to 19.3% (the highest in more than a decade), capping a year that saw the nation's jobless rate soar to double the Euro- zone average. According to the Merco Press, the number of people registering for unemployment benefits increased by 54,657, or 1.41 percentage points from November to 3.92 million. From a year earlier, unemployment climbed by 25%; youth unemployment is now 40 per cent. The only good piece of news this year was that the number of jobs destroyed in 2009 was 200,000 less than in 2008. That's the sort of statistic which, in the US would likely prompt grave warnings about the need to pursue "exit strategies".

Spain, like the other countries within the European Union (EU), has other problems, because the nation has voluntarily decided to accede the so-called "Stability and Growth Pact" (SGP), which arbitrarily limits national government deficit spending to 3% of GDP, whilst limiting overall public debt as a percentage to GDP of 60% (even though there is no economic theory in evidence to justify these arbitrary figures). Since the inception of European Monetary Union (EMU), the conflict within the EU on how to co-ordinate economic policy on the supranational level has been recurrent. It fully illustrates the core problem at the heart of the EMU and its related Stability and Growth Pact. Politically, the interpretation of the euro zone's stability pact is largely left in the hands of unelected bureaucrats, operating out of institutions which are devoid of any kind of democratic legitimacy.

More fundamental are the institutional flaws. The relation of member countries to the European Monetary Union (EMU) is more similar to the relation of the treasuries of member states of the United States to the Fed than it is of the US Treasury to the Fed. In the US, states have no power to create currency; neither do the countries within the EU. By the same token, purchasers of US state bonds do worry about the creditworthiness of states, and the ability of American states to run deficits depends at least in part on the perception of creditworthiness. While it is certainly true that an individual state can always fall back on US government help when required (although the recent experience of California makes that assumption less secure), it is not so clear that the individual countries in the euro zone are as fortunate.

The euro dilemma that Spain faces, then, is somewhat akin to the problems of a country like Iceland or Latvia. They operate under a system which prevents their government from spending money freely - precisely the sort of thing that the deficit terrorists in the US advocate on a regular basis (particularly those who call for constitutionally mandated balanced budgets, as exists in many state budgets).

Facing a worsening economic situation, the Spanish government has done what any reasonable fiscal authority would do and that is to expand its budget deficit. A significant proportion of the rising deficit is being driven by its automatic stabilizers, which is normal and sensible. But their impact to stabilize incomes is negated to a large degree by the SGP.

Why it's Folly to Balance Budgets During a Recession

Spain illustrates the futility of seeking to impose balance budgets during a recession. It makes things worse. Budgets inexorably tend to deficit when economic activity slows and tax revenues collapse. If not addressed soon, this structural flaw at the heart of the European Union suggests problems ahead for the long-run viability of the euro, and certainly points to growing intra-European political tensions. (In that regard, it is interesting to note the recent comments by the Mayor of Athens in regard to Greece's comparably adverse unemployment situation: "Germany owes us €10.5bn from the 2nd World War, they should give us that back and we can equate it all up, automatically our deficit falls to 5%...").

The debate about public debt limits is arcane in the extreme and harks back to gold standard logic which is no longer applicable. It was always clear - by the nature of the structure of their monetary system (divorce between the fiscal and monetary sovereignty) that the system would not cope in a major economic crisis such as now, where unemployment is skyrocketing. As much as one can complain about the size and direction of the US government spending, the country at least is in a position (should it choose to do so) to exercise fiscal leadership, and the institutional capacity to implement it. But if the US imposes anything like the constraints on government spending demanded by the deficit warriors, we'll have Spanish style levels of unemployment.

The Spanish government does not have the ability to provide fiscal leadership in their winter of recession because of the voluntary constraints they have imposed on their fiscal capacity courtesy of EMU membership. That is why almost one in five Spaniards is now unemployed, with no prospect of respite. With the degree of fiscal maneuver limited in all EU nations, growth in the euro zone depends on 1) a low enough interest rate to fuel private domestic spending (probably requiring asset bubbles, as in Spain, Irish housing markets), 2) entrepreneurial innovation, and 3) cost cutting, the last of which tends to suppress domestic demand. The net result has been a region has been left largely on a stagnant growth path since unification because it cannot run large enough current account surpluses given Asian cost structures and Asian exchange rate linkage to the US dollar (although it has tried to use relocation of production to Eastern Europe to gain an edge). The euro region basically rides on the back of global growth, which previously depended on the Anglo private sector deficit spending, which was largely sponsored by asset bubbles.

Having shut down their policy options in order to discipline themselves, they are stuck in a hard grind, which now will get even harder as fiscal retrenchment is attempted. Perhaps enough people will conclude after a decade of trying to work within a number of self-imposed policy constraints, it is time to try something else. I wonder how long the euro in its current incarnation can last? Is this really what the US wants? Because that is the ultimate implication of a policy which arbitrarily seeks to constrain government spending in the manner in which the Karl Roves, Robert Rubins and Pete Petersons of this world are currently advocating.

Getting Government Spending Right

So what is the "right" level of government spending? Obviously, we want the government spending to be done efficiently. We don't want government spending to become inflationary. Keep in mind -- the public purpose behind government doing all this is to raise an army, operate a legal system, support a legislature and executive branch of government, promote public infrastructure, promote basic research, etc. So there are quite a number of tasks that even the most conservative voters would have the government perform.

Ultimately, the ‘right amount of government spending' is an economic and political decision that has nothing to do with government finances. The real ‘costs' of running the government are the real goods and services it consumes; the real cost of the government using all these real goods and services is that those resources would other wise be available for the private sector. So when the government takes those real resources for its own purposes, fewer real resources are left for private sector activity. What matters is that taxes are set to balance the economy and make sure it's not too hot or not too cold. And government spending is set at the ‘right amount' to provide the requisite services and full employment. Getting caught up in the mythology of "financing" considerations or arbitrary self-imposed constraints with no bearing in any economic theory at all is the wrong path. That way lies Spain. Is this the future we want for the US?

Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.