In Debt We Trust?

Is it time to consider more radical strategies for repairing the U.S. economy? Perhaps, although as a recent essay from the Levy Economics Institute argues, it’s also clear that the old game of trying to reflate bubbles isn’t going to work this time.

“Like the Bush administration before it, the Obama team appears to be trying to re-create the bubbly financial conditions that led to disaster,” a research paper from LEI asserts. “This tack is not likely to succeed, and it is displacing policies that might actually prevent a recurrence of the Great Depression.”

The paper continues,

In our view, most administration proposals are fundamentally misguided, since they are based on the twin presumptions that Big Banks face only a liquidity problem and that, if this problem is resolved, the economy will recover. We believe these presumptions are entirely mistaken. The Big Bank problem is insolvency, and these banks should not be saved because they form a barrier to a sustainable recovery. Given a chance, they will resurrect the bubble conditions that led to the current crisis.

What’s the solution? LEI argues that a banking “holiday” is needed. The biggest institutions are temporarily closed and the books are closely analyzed, including a careful look at cross-bank liabilities. The immediate goal is “consolidating the balance sheets” in order to “downsize the financial sector and reduce monopoly power.”

The basic motivation for these changes, according to LEI, is that borrowers can’t service their debt. But the think tank’s solution isn’t exactly novel. “A major increase in government spending is the only way to smooth the deleveraging process.”

The reasoning, the paper concludes: “It is better to spend on a much bigger scale now in order to create jobs and rekindle private sector growth. If we do that, the budget deficit will shrink and GDP will grow, while government debt- and deficit-to-GDP rates will fall.”

Even assuming that huge amounts of new spending are the intelligent choice (a debatable proposition, to say the least), the conceit here is that Congress will make intelligent decisions when it comes to directing the new monies.

Ultimately, there’s a question of whether the government, any government, can create jobs worthy of the name on a grand scale over long periods of time. One problem: the funding of such a massive public enterprise has to come from somewhere, which raises questions of whether we’re simply borrowing from Paul to pay Peter. There are three basic methods for such programs: raise taxes, borrow more, or quietly devalue the currency. Perhaps a mix of all three is coming.

Yet the burden should be on those who call for a colossal increase in government’s role at this juncture in the economic cycle. Does history suggest this is a logical path that will bear fruit? We think not, although the devil’s in the details. But as a general proposition, economic growth doesn’t flow from government mandates. Governments have some capacity for keeping disaster at bay, but that’s quite a different state of affairs than promoting growth.

We can make a case for intervention to stave off some immediate threat. But let’s not fool ourselves into thinking that economic expansion can be engineered as one more state program. The limited response (so far) of the so-called stimulus program from earlier this year suggests as much. Clearly, many disagree, although the “solution” in some corners is always: spend more. If $800 billion wasn’t enough, $1.6 trillion would have been. Ah, if it was only that easy.

And so we ask a simple question: What does history say? To be precise, what does history say about government spending on promoting growth beyond some immediate crisis?

By all means, we need to encourage economic expansion by all reasonable methods and use government levers in a prudent fashion. But there are limits to everything, just as public spending at some point becomes counterproductive. And so let’s not kid ourselves: we’re looking at a period of subpar growth on a number of levels, and the brilliant ideas cooked up in, say, the U.S. Senate or the Department of Energy probably can’t save us from this fate.

The only thing worse than an unsatisfactory recovery is one that’s also laden with an even higher level of excess debt and unsustainable levels of public sector expansion.

About James Picerno 894 Articles

James Picerno is a financial journalist who has been writing about finance and investment theory for more than twenty years. He writes for trade magazines read by financial professionals and financial advisers.

Over the years, he’s written for the Wall Street Journal, Barron’s, Bloomberg, Dow Jones, Reuters.

Visit: The Capital Spectator

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