Will Germany Drag World Economy Into Another Great Depression?

Economics / Great Depression II
May 22, 2010 - 11:32 AM

By: Mike_Whitney

Deficits create demand. Demand generates spending. Spending generates economic activity. Economic activity generates growth. Growth generates jobs, increases government revenues, reduces deficits and ends recessions.

Simple, right?

When consumers have too much debt, they will not spend no matter how low interest rates are. This is not theory, this is fact.

If the government cuts spending at the same time as consumers, then overall spending declines and the economy slips into recession. This is what the deficit hawks want--a return to recession. This is politics, not economics.

KEYNE'S KOAN: Increasing the deficits, lowers the deficits

The deficit hawks say "You can't solve a debt problem by adding more debt". This is a very persuasive argument, but it's wrong. Increasing the deficits, lowers the deficits. This sounds wrong, but its right. Here's proof from a recent article by economist Marshall Auerback:

"Ireland began cutting back deficit spending in 2008, when its banking crisis began to spread and its budget deficit as a percentage of GDP was 7.3 per cent. The economy promptly contracted by 10 per cent and, surprise, surprise, the deficit exploded to 14.3 per cent of GDP." ("The US is not Greece", Marshall Auerback, counterpunch.org)

Ireland is not the exception. Ireland is the rule. A nation cannot starve itself to prosperity nor can it shrink its way to growth. Austerity is fine for monks, but bad for the economy.

Deficit cutting during a downturn creates bigger deficits, higher unemployment, greater economic contraction, and more suffering. Every country that follows the IMF's prescription for belt-tightening, undergoes a mini-Depression. That's because its bad economics (or, rather) politically-driven economics. By weakening the state, private industry and speculators hope to grab public assets on-the-cheap and force privatization of public services. These are the real objectives behind the austerity measures.

When the government is in surplus, the private sector must be in deficit. When the government is in deficit, the private sector must be in surplus. It's that simple. So, when consumers and households must save to make up for lost equity and falling revenue, (such as, after the collapse of the housing bubble) the government MUST increase deficits to keep the economy running, to reduce slack in demand and to lower high levels of unemployment. Without Obama's fiscal stimulus, the economy would not have produced 3 quarters of positive growth. The stimulus (and monetary policy) kept the economy from tipping into a severe recession. Had Obama followed the advice of the deficit hawks (many of who also supported Bush's wars in Iraq and Afghanistan) the country would be mired in another Great Depression. This is worth considering when some Fox bimbo in a plunging-neckline says "The stimulus did nothing."

Sovereign governments whose debts are paid in its own currency, are not like you and me. They are not fiscally constrained or required to balance their checkbook. Nor should they if it weakens the economy or increases unemployment. The government can spend without risk of going broke because the debt is owed to itself. Yes, this can create inflation when unemployment is low and there is too much money chasing too few goods. But that should not deter government from stimulating the economy when unemployment is 10%, underemployment is 20%, manufacturing is slow, housing is in a shambles, core CPI is below 1%, and the economy is teetering towards outright deflation. Deficits should be increased and sustained at a high level until unemployment and overcapacity begin to retreat. Economists know that consumer deleveraging is a long-term project, which means that government stimulus will be required for a very long time. Get used to it.

Last week, economist James Galbraith was interviewed by the Washington Post's Ezra Klein. Klein asked Galbraith if he thought "the danger posed by the long-term deficit is overstated by most economists?" Here's his answer:

James Galbraith:"I think the danger is zero. It's not overstated. It's completely misstated.

Ezra Klein--"Why?"

James Galbraith---"What is the nature of the danger? The only possible answer is that this larger deficit would cause a rise in the interest rate. Well, if the markets thought that was a serious risk, the rate on 20-year treasury bonds wouldn't be 4 percent and change now. If the markets thought that the interest rate would be forced up by funding difficulties 10 year from now, it would show up in the 20-year rate. That rate has actually been coming down in the wake of the European crisis.

So there are two possibilities here. One is the theory is wrong. The other is that the market isn't rational. And if the market isn't rational, there's no point in designing policy to accommodate the markets because you can't accommodate an irrational entity." (Washington Post)

Naturally, Galbraith's answer stirred up controversy at the Fox School of Economics where Andrew Mellon's photo is still proudly on display. But Galbraith is right. If the markets were really worried, then yields on long-term Treasuries would go up. But they're not going up, because the economy is still battling deflation. The 10-year Treasury is presently 3.4%, just as one would expect in a Depression. On Wednesday, core CPI came in at 1%. There is no inflation in the system. The inflation doomsters are discredited alarmists who should be ignored. The economy needs more stimulus, more government spending. Here's Galbraith again:

“To put the point firmly.... the economy is recovering because of the budget deficits. Without these budget deficits, there would be no recovery, because it is the deficits that are helping to put more money into households’ pockets. To talk of recovery but to criticize the deficits is ridiculous. The whole point of this thing [stimulus spending] is to add to the deficit. The patient is recovering from a deadly illness and yet the press is attacking the medicine....â€