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Will Germany Drag World Economy Into Another Great Depression?

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

By: Mike_Whitney

Economics

Best Financial Markets Analysis ArticleDeficits 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....”

"The deficit and the public debt of the U.S. government can, should, must, and will increase in this crisis. They will increase whether the government acts or not. The choice is between an active program, running up debt while creating jobs and rebuilding America, or a passive program, running up debt because revenues collapse, because the population has to be maintained on the dole, and because the Treasury wishes, for no constructive reason, to rescue the big bankers and make them whole.” ("Galbraith: deficits are the solution not the problem", John Hanrahan, Nieman Watchdog)

Not all deficit spending is good. John Maynard Keynes never advocated bailing out underwater financial institutions run by crooks, and yet, that has been the essential Fed policy from Day 1. Keynes believed that markets were fundamentally unstable; that government had a role to play in smoothing out capitalism's excesses, reducing inequality and creating jobs. He also believed that slumps will last much longer than necessary if government does not intervene and stimulate demand.

The value of deficits depends on how the money is spent. The $700 billion TARP was largely wasted on financial institutions that should have been nationalized, broken up, and their toxic assets put up for auction. The $787 billion stimulus, on the other hand, was largely a success, because it provided urgently needed relief for the states, benefits for unemployed workers, tax cuts and infrastructure programs. Experts belief the stimulus increased employment by roughly 2 million workers and raised GDP by 1.5% to 2.5%. Stimulus is not a panacea, and no one ever said it was. It's an emergency blood-transfusion to get a sickly patient through a violent trauma. It did what it was designed to do, and it paid for itself via the uptick in economic activity and growth. Here's how Paul Krugman sums it up:

"...increasing government spending in a slump more or less pays for itself: it leads to higher output not just in the short run but in the long run, and therefore leads to higher revenue that very likely more than offsets the original expense." (Paul Krugman's blog, "The Conscience of a Liberal", New York Times).

Stimulus critics may want to memorize the Krugman quote. Or, maybe, this from the April 2010 IMF World Economic Outlook:

"Fiscal policy provided major support in response to the deep downturn, especially in advanced economies.....Fiscal balances have deteriorated, mainly because of falling revenue resulting from decreased real and financial activity. Fiscal stimulus has played a major role in stabilizing output but has contributed little to increases in public debt, which are especially large in advanced economies." (Found at Billy Blog, Bill Mitchell)

Repeat: Stimulus has "contributed little to increases in public debt." In other words, the giant deficits are not the result of stimulus (or so-called "profligate" public spending) but of "falling revenue" because the economy is still flat on its back. The message is simple; put people back to work, increase demand, restore public confidence, and spend more money. Now.

MELTDOWN IN THE EU: What happens when deficit hawks set policy

Global markets have plunged for more than a month, wiping out more than $5.3 trillion in total market value. Ostensibly, the catalyst was Greece's large deficits, but that's only part of the story. Under the terms of the Maastricht Treaty, (aka--the Treaty on European Union) EU countries are not allowed to exceed the treaty's 3% ceiling on fiscal deficits. The nonsensical treaty basically repeals the business cycle by edict. Are recessions forbidden, too?

Sanctimonious German bureaucrats and heads-of-state have taken up the cause of fiscal probity and turned a thoroughly-manageable matter into a full-blown crisis that could break up the EU and drag the world back into deep recession. Keep in mind, Germany has been the main beneficiary of Greek deficits as reflected in their bulging surpluses. One does not exist without the other; and as Keynes pointed out, surplus countries increase global instability by exerting "negative externality". That hasn't stopped German media from finger-wagging at their "spendthrift" neighbors to the south.

Now markets are in a frenzy; volatility has skyrocketed and gauges of market stress (Libor) are steadily rising. Interbank lending has begun to slow. Greek deficits have uncovered the systemic-rot in the EU banking system which is overloaded with garbage assets and non performing loans, only the EU does not have the fiscal/political infrastructure in place to guarantee the dodgy paper. So the pressure on the banks continues to grow and the prospect of another Lehman crash looms larger by the day.

Meanwhile, in Berlin, embattled politicians--who are 100% certain that the "everyone else is to blame"--are sticking to their Hooverian economics plan; balanced budgets, austerity programs, fiscal straight-jackets all around. This is the deficit hawks remedy, too, the Hoover Solution. Take a good look; this is what the U.S. will look like if the Keynes-bashers, the belt-tighteners, and the deficit gloomsters get their way. Great Depression 2.0. Bet on it.

By Mike Whitney

Email: fergiewhitney@msn.com

Mike is a well respected freelance writer living in Washington state, interested in politics and economics from a libertarian perspective.

© 2010 Copyright Mike Whitney - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

Mike Whitney Archive

© 2005-2014 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Comments

stimulus part II
24 May 10, 20:31
mike i think this is true

the german hyperinflation was caused by speculators shorting the currency into oblivion....the country actually got out of a depression like state by furious gov't spending later......but a good point was made that the choice regarding increased spending falls on wether it is done on rebuilding america.....(like germany did for themselves in my example above) or wether it is done to keep unemployment compensation going...and bailing out the banksters....well we better hope for both....and the fed will monetize the debt in a treasury circle jerk....and so long as the fed pays banks nearly 1 % to park excess reserves lending (and inflation) will be no threat.


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