Franklin D Roosevelt’s mistake wasn’t boosting the economy with government spending, it was heeding the advice of the deficit hawks when he sought re-election and tipping the US economy back into recession.
Larry Elliott, economics editor
The Guardian, Monday 14 June 2010
The Germans are doing it. The Greeks, the Spanish and the Portuguese believe they have no choice but to do it. George Osborne believes it is his patriotic duty to do it. Around the world, cutting budget deficits has become the priority for policymakers fearful that rising debt levels will leave them at the mercy of capricious financial markets.
Mervyn King has applauded the return of fiscal conservatism. So has the Organisation for Economic Co-operation and Development. Two months after they urged that budgetary support be maintained until recovery was fully entrenched, finance ministers and central bank governors from the G20 said they welcomed the plans announced by some countries to begin deficit cutting without delay.
Budget deficits are certainly high across the G20 and beyond. But they are high primarily because of the severity of the worst recession since the second world war and because of the action taken collectively by governments to prevent that recession turning into something far, far worse.
As things stand, a second Great Depression has been averted, but growth has ranged from the weak in Europe to the unspectacular in the United States. Banks are not lending. Unemployment is running at near double-digit levels in the US and the eurozone. The determination to cut budget deficits in these circumstances does not show that policymakers of probity and integrity have replaced the irresponsible spendthrifts of 2008 and 2009. It shows that the lunatics are back in charge of the asylum.
As evidence, take David Cameron’s warning last week about the need for austerity. The prime minister said: “Nothing illustrates better the total irresponsibility of the last government’s approach than the fact that they kept ratcheting up unaffordable government spending even when the economy was shrinking.”
This brought the apt riposte from Marshall Auerback of the New Deal 2.0 thinktank. “So we’re supposed to ratchet up government spending when the economy is growing? When it can present genuine inflationary dangers? If this is the type of policy incoherence we have in store, then God help the United Kingdom.”
There are economically literate members of the government capable of pointing out to the PM that he is talking dangerous nonsense. Vince Cable is one. Chris Huhne is another. Sadly, though, the Liberal Democrats seem unwilling or unable to mount an argument against policies that now threaten to repeat the mistakes of Japan in the 1990s, when every tentative recovery was snuffed out by over-hasty retrenchment.
Let’s start with a bit of history. The budget hawks like to cite Geoffrey Howe’s draconian 1981 budget as evidence that fiscal tightening is perfectly consistent with economic growth. So it is, providing there is scope for an over-valued pound to depreciate and for excessively high interest rates to be cut. So it is, provided that tumbling oil prices raise the real incomes of consumers and cut costs for businesses. All these things happened in the early 1980s; none of them are likely to occur now. The pound has already fallen by 25%, interest rates are at 0.5% and oil prices show no sign of falling much below $70 (£48) a barrel.
The real historical comparison is not with 1981 but, as the American economist Paul Davidson notes, with the US in 1937. On arriving in the White House in 1933, Franklin D Roosevelt used government spending and tax breaks to boost the economy. The US ran deficits of between 2% and 5% during FDR’s first term but, while the economy started to pull out of the deep trough reached in 1932, the national debt rose from $20bn to $33bn .
Coming up for re-election, Roosevelt heeded the advice of the “sound money” economists who delivered the same sort of warnings that we are hearing today: the US was running unaffordable budget deficits that would impose an intolerable burden on future generations. The budget for 1937 was slashed and the US economy promptly went back into recession. Falling tax revenues meant the budget deficit rose to $37bn.
When deficit spending resumed in 1938, the economy started to grow again but did not fully recover until the US entered the second world war. The deficit hawks disappeared into obscurity as the need to win the war trumped all other considerations. By 1945, the US budget deficit stood at more than $250bn or 120% of GDP.
But the beneficial spin-off from the war effort was that the domestic economy was humming. Resources that had stood idle in the 1930s were fully utilised and there was full employment. Strong growth brought both the annual deficits and the size of the national debt down in the 1950s. Far from being burdened with unpayable debt, the baby boomers born in the late 1940s and 1950s were the most blessed generation in history.
That’s enough history. Just as in 1937, private demand in most advanced countries is too weak to sustain the recovery. Budget deficits are a reflection of high unemployment and low levels of private investment. They are also a reflection of the big financial surpluses that have been amassed in the private sector. Animal spirits, in Keynes’s phrase, are low. Consumers are worried about losing their jobs and are having their incomes squeezed. That makes businesses anxious about investing.
Charles Dumas of Lombard Street Research has put some hard numbers on this trend. In the US, the private sector was in deficit by 4% of GDP in 2006 but is now running a surplus of 8% of GDP. In Britain, the corresponding move was from a 1% deficit to a 10% surplus. He estimates that the global private sector surplus is now $3.3 trillion.
These are counter-balanced by pubic sector deficits that also total $3.3tn. The public sector, in other words, has been compensating for a lack of private demand. This spending was not “irresponsible”, although a collective attempt to rein in deficits when the private sector recovery is so anaemic certainly would be.
Dumas notes: “If some countries deflate their economies in an attempt to cut their government deficits, other countries will have a larger deficit – and even the deflating countries will be partially frustrated in their endeavours. Why? Because they will induce a renewed recession that will hammer tax revenue and enforce greater relief spending.” The result, he warns, “will almost certainly be renewed European recession, quite possibly a prolonged depression”.
So why are they doing it? Is it, for all Nick Clegg’s guff about “progressive cuts”, that the real agenda is to complete the demolition job on welfare states that was started in the 1980s? Or is simply that the deficit hawks are simply crackers?
Either way, we now have the bizarre spectacle of China, Japan, the eurozone and Britain all set on reducing budget deficits while simultaneously pursuing export-led growth. This is a logical absurdity because somebody, somewhere has to be importing all the exports. If the rest of the world assumes that the US is once again going to become the world’s spender of last resort it is seriously mistaken.
Paul Krugman calls this “utter folly posing as wisdom”. Sovereign debt problems are confined to those eurozone countries that have no way to deal with their productivity problems other than to deflate savagely. Bond markets are not freaking out about budget deficits in Britain, the US or Germany, but let’s see how they react to a return to the mass unemployment, protectionism and political extremism of 1930s.