Friday, November 26, 2010

Galbraith Critique of Deficit Commission

Galbraith's critique is devastating. It is not about fixing deficits by figuring out the best way to cut spending or by changing the tax system. I don't know why his critique has been ignored by the media. If nothing else, it is certainly more interesting and newsworthy. I have summarized the report which he delivered to the Commission below.

He cited a study by the IMF which laid the cause of the world wide recession to the financial crisis which slowed economic growth and led to high unemployment rates, and consequently, lower tax revenues and a rise in transfer payments to the unemployed. The conclusion is that only 10% of the budget deficits are due to increased public spending for economic stimulus. Therefore, the only way to reduce deficits due to unemployment, is to take the steps necessary to reduce unemployment. Cutting public spending or raising taxes cannot reduce deficits due to unemployment.

He then argues that since high unemployment is due to the financial crisis, we must remedy the financial crisis to increase private credit, instead of relying on government and public debt. He asks the Commission why fixing the financial system was not on its agenda while entitlements, which are not the root cause of our deficits has been placed at the top of the agenda. He states that debt restructuring for households would restore private credit, and that reconstruction of the banking system by purging it of toxic assets, and replacing the management which caused the crisis, as well as the compensation system which provided the incentive for poor risk management, would fix the financial system. He went on to show that private credit was the cause of the boom in the Clinton administration which led to budget surpluses. The use of public credit to restore employment is only necessary when the private credit system is not working.

He then moves to the Commission's focus on entitlement spending. His major point is that entitlements, like Social Security and Medicare, are not regarded as government spending in the calculation of GDP because they do not consume resources. They are transfer programs which are irrelevant to deficit reduction. As transfer programs, they reallocate income from one consumer (taxpayers) to another (retirees). One could argue the merits of income reallocation on questions of fairness etc. but it is false to argue that the programs can become insolvent. The are just like any other government program funded with tax revenues, and they can only become insolvent if the government becomes insolvent. Since the revenues from payroll taxes are not sequestered, and are used for any purpose decided by government, it doesn't make any more sense to talk about entitlement insolvency than it does to refer to defense spending and insolvency. From Galbraith's perspective, the attack on entitlement spending is merely an attack on income redistribution and the so called welfare state. This is a perennial target of attack by conservatives.

He ends his critique by showing the flaws in the claim that we will be punished by the bond market with higher interest rates if we do not balance the budget. He points out that the current yield on long term government bonds is very low. The bond market does not seem to be concerned about the risk of default on government debt. It can be argued that the bond market can be fickle and change its mind. But in that case, the assumption must be that the bond market is not rational, and that it is impossible to predict what it will do under any circumstance. Moreover, the assumption used to forecast large increases in future interest rates, which is responsible for substantially higer interest payments relative to GDP by 2050, is not consistent with the assumption that inflation will be only 2%. We don't have high interest rates when investors do not price in an inflation premium.

He points out that there is a risk to dollar depreciation but that might reduce our trade deficit. His last point is that there is a strong relationship between our trade deficits and the amount of US debt held by international investors. As long as we have large trade deficits, international investors will have to find a way to invest the dollars that they accumulated along with their trade surplus with the US. If we want to reduce our dependence on foreign lending we will have to reduce our trade deficits.

No comments:

Post a Comment