The debate over whether deep federal spending cuts would slow the nation's economic recovery intensified this week.
One side says job losses will grow as government spending shrinks, while the other insists private jobs will flourish only when government retreats.
Supporters from each side cranked up the volume after Mark Zandi, chief economist at Moody's Analytics, released a report that predicts GOP spending cuts would lead to job losses of up to 700,000 through 2012.
Zandi's assessment came on the heels of a new Goldman Sachs analysis suggesting that the GOP deficit reduction plan would shave 2 percentage points from the gross domestic product, a measure of the value, including government spending, of all goods and services produced in the country. Most economists predict GDP will grow about 3 percent this year, a reasonably healthy pace. If the figure were to fall to 1 percent, the labor market would suffer.
Some conservative economists argue that potential job losses are being overstated and that a credible plan to begin paring down the nation's historic deficit would help job growth. It could do that by reducing market uncertainty and encouraging private investment.
To define the arguments of both sides — and to get an idea of common ground on which deficit hawks and doves could come together — we put questions to two prominent economists:
Alan Viard of the free-market think tank American Enterprise Institute
Michael Ettlinger of the liberal Center for American Progress, which Tuesday released a letter signed by more than 320 economists who say the economic recovery would be damaged by cuts proposed by the GOP.
Can a persuasive argument be made that reducing federal outlays won't affect the GDP, at least in the short term? Are job loss projections by Zandi and others overstated?
Viard: In the short run, a reduction in federal spending is likely to reduce GDP to some extent, by lowering aggregate demand, although the reduction is likely to be significantly smaller than Zandi and others have estimated.
In the medium run, however, lower aggregate demand translates into lower inflation, rather than lower GDP. And, in the long run, a reduction in federal spending actually promotes economic growth, by making room for greater private investment, which boosts the capital stock and real wages.
Ettlinger: If a component of GDP, such as government spending, falls, then GDP falls — unless, of course, another component increases. Under current economic conditions, there is little reason to believe that will occur. That's why economic models show large job losses.
Spending is pulling resources off the sidelines and into the economy, boosting GDP. While not every dollar of federal spending is spent optimally for economic growth, much of it is critical. Cutting it can have very significant negative effects now and for long-term growth.
Many economists argue that, while there is historic basis for the theory that government spending can "crowd out" desired private investment in the economy, such a theory does not apply when now we have low interest rates, low capacity utilization and an accommodating Federal Reserve monetary policy. Do you agree?
Viard: Even if crowding out is small under current conditions, it will become larger as the economy improves. It is important to quickly adopt policies that put federal spending on a more restrained path, while deferring the implementation of large spending cuts until the economy is stronger.
Ettlinger: For something to be "crowded out" there has to be a crowd. When it comes to private investment, there is no crowd right now. It's 1 a.m. in downtown Phoenix. If we want a crowd, the government is going to have to bring it in.
And right now it can be done. The people are willing (interest rates are near historic lows), the roads are clear (low capacity utilization), and the traffic lights are perfectly timed (the Fed is accommodating). We have over 14 million people out of work, keeping costs low. Government needs to continually update infrastructure and make other investments; doing so now when there is little competition for workers or raw materials is the cost-effective and smart thing to do.
If the government pulls back spending, what will cause businesses to start hiring workers? And would you then advocate that the Fed pull back on its efforts to stimulate the economy — like its $600 billion bond purchase program?
Viard: A pickup in hiring, which may take some time to occur, will eventually be triggered by self-corrective forces in the economy, amplified by the vast amount of fiscal and monetary stimulus that have been provided in the last three years. The pace at which the Federal Reserve can pull back on its stimulus will depend on the pace of the recovery and on the inflation outlook.
Ettlinger: There is no realistic mechanism to suggest that government pulling back on spending is going to cause businesses to start hiring workers. Why is cutting back on government food safety inspections going to produce additional hiring? Businesses are to a significant degree waiting for more certainty in demand. Cutting public spending will make them more gun-shy, not less.
Economist Richard Koo has referred to the current economy as in a "balance sheet recession," with borrowers and lenders performing needed repairs to their balance sheets "instead of maximizing profits." In House testimony, he argued that the government should not embark on "fiscal retrenchment" until the private sector is healthy enough to borrow and spend money left unborrowed by the government. What argues for or against his assessment?
Viard: Major fiscal retrenchment should not be implemented until the economy is strong. But, it is important to quickly adopt policies that address the long-term fiscal imbalance, with implementation of those policies taking place as the economy improves.
Ettlinger: The "balance sheet recession" may be true for households and for some financial institutions, but is it much less true for the corporate sector. Corporations aren't fixing their balance sheets — they're waiting for demand to return before they start investing and hiring en masse. Yes, households have too much debt, but their balance sheets are also being held back by high unemployment and stagnant family incomes. These problems need to be addressed, and cutting government spending moves us in the opposite direction.
The November election has been interpreted by many as voter frustration with red ink, as opposed to frustration with high unemployment. How might the psychological effects of stay-the-course government spending vs. reduced government spending play into business and consumer behavior going forward?
Viard: The adoption of a bipartisan agreement to address the long-run fiscal imbalance would have positive effects on consumer and investor confidence and would hold down long-term interest rates.
Ettlinger: I am skeptical that there will be a psychological effect of any importance. The economy is slowly coming back. At this point it's unlikely that it will backslide precipitously unless something dramatic happens. It's the policy and market dynamics, not the psychology based on perceived government action, that will determine behavior.
Can you suggest a path to a place where "deficit doves" and "deficit hawks" can find common ground that will encourage the economy's recovery and also provide what George Magnus, an economist with UBS, characterizes as a "transparent and plausible" medium-term plan to lower the deficit and public debt?
Viard: The resolution of the long-term fiscal imbalance will ultimately occur on a bipartisan basis. The plans put forward by the Bowles-Simpson commission and the Bipartisan Policy Center illustrate the potential for bipartisan agreement. Addressing the long-run fiscal imbalance is likely to require both revenue increases and spending restraint. Although distributional concerns must also be considered, long-run growth will be strongest if entitlement spending restraint, particularly in Medicare, is a large part of the final package.
Ettlinger: The divisions that matter are not between deficit hawks and doves. Most of the doves want deficit reduction, too, just at a later point in time. Most of the hawks are really deficit "peacocks" — talking about deficit reduction but not standing up and showing how they'd achieve it. Few except the president are willing to talk about any taxes, let alone taxes at the level that are needed. All sides need to agree on a plausible medium-term goal. The president has offered a plan to get the deficit down to around 3 percent of GDP in five years. That's a good goal. We could set a more ambitious goal, such as a balanced budget. That would, however, be counterproductive. The country has not been prepared for what that would entail, and elected officials are not ready to spell it out. There has to be an agreement that this will take both spending cuts and tax increases. Doing it all through spending cuts would be deeply injurious to the country. Most members of Congress know this. Until that happens, it isn't a serious discussion.
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