Barack Obama: “if we keep on adding to the debt… that could actually lead to a double-dip”

Barack Obama has now come clean about his thinking on why his administration has decided to focus first on reducing the deficit and next on jobs. He fears a double-dip recession will occur if foreigners lose confidence in the U.S. dollar, causing interest rates to spike. 

This is nonsense and it demonstrates how much at odds Obama’s economic thinking is with reality. This is the clearest indication that the Obama Administration doesn’t understand how modern money works. In fact, by focusing on deficit reduction, he has increased the chances of a double dip instead of decreasing them.

If he wants to reduce deficits, knowing it will precipitate a double dip and would decrease malinvestment. Fine. That’s not my solution, but it is accurate view of the economics.

What Obama actually said

At issue is whether the federal government’s enormous debt burden in the U.S. could cause investors to lose confidence in the U.S. government and shun its debt.

In an interview on Fox News today, the President said the following:

I think it is important though to recognize that. If we keep on adding to the — Even in the midst of this recovery that at some point. People could lose confidence in the US economy in a way that could actually lead to a double dip recession.

Is this really true though?

How deficits really work

Think of an economy this way: the people in any economy buy goods and services from one another and from the outside. In any given time period, one person, one company or one group/sector might use credit in order to buy more goods and services than it makes in income. It’s like spending future income by using credit. This puts that individual, company or group/sector in deficit i.e. they have spent more money than they have earned. Now obviously, if one sector is in deficit in a given period (i.e. they have spent more capital than they have earned), then the other sectors are in net surplus (i.e. they have received more cash than they have earned).

Let’s give these groups/sectors of the economy names: the private sector, the public sector and the foreign sector.  Giving the groups names makes it plain that if the public sector is in deficit, the combined foreign and private sectors must be in surplus.  Simply put, if you look at all of the households and businesses that make up the private sector and aggregate them together, you can determine if the private sector has a net surplus or a net deficit in any individual time period. And if the private sector has a net surplus, the combined foreign sector and public sector must have a deficit for that time period. The sector financial balances move in concert.

What this means for today is that a government which reduces its deficit in a given time period is forcing an equal reduction in surplus in the private and foreign sectors. So that means, in aggregate, the private sector and the foreign sector will reduce the surplus cash it is taking in over what it spends.

Scott Fullwiler has a good graph depicting how the private sector surplus/deficit moves in concert with the public sector deficit/surplus, the difference being the current account deficit:

We can look historically at how these sector financial balances have moved over time. Figure 2 shows how closely the private sector surplus and the government sector deficit have moved historically, which isn’t surprising given they are nearly the opposing sides of an accounting identity. The difference between them, more visible starting in the 1980s, is the current account balance.

Figure 2: Historical Behavior of Private Sector Surplus and Government Sector Deficit as a percent of GDP

private-public-sector-balance

 

Below, I am now providing figure three from Fullwiler’s post at reader request, as it shows the current account deficit as the missing link since the 1980s.

financial-sector-balances

Unless the increasing current account deficit switches direction violently, this can only mean that reducing the government’s deficit reduces the private sector’s surplus. Net-net, the government’s decreased deficit spending will decrease savings in the private sector. And no deleveraging can occur if savings in the private sector are reduced.

Is that what we want? Reduced private savings means continued high private sector leverage. In the U.S., the private sector has much greater debt burdens relative to the size of the economy than the federal government does. You would think we want the private sector to reduce leverage more than the public sector.

Long-term deficit reduction

What I have suggested is long-term deficit reduction.  If the President is concerned about deficits as far as the eye can see, he might want to look at retiree healthcare costs.  In June I said:

Yesterday, I argued that the United States faced a policy dilemma in avoiding debt deflationary forces while maintaining fiscal prudence.  The reality is that President Obama faces political constraints in Washington right nowregarding budget deficits.  He is not likely to get another stimulus package through the Congress unless he can credibly demonstrate a longer-term deficit reduction outlook.  In my view, this necessarily means changes to Social Security and/or Medicare.

But, of course, President Obama is not going to do that because this would mean cutting Medicare benefits, a political loser.

This looks like Hoover more every day

The President just doesn’t seem to understand how the economy works frankly. Reducing deficits by cutting spending or raising taxes decreases aggregate demand. And it is a decrease in aggregate demand which would induce a double-dip recession. So, the President’s logic just doesn’t work.

But what about a strike on U.S. government debt?  As you probably surmised from the above, if the U.S. private sector is increasing its savings, there is automatically a greater domestic bid for U.S. treasury securities.  So, it is a misnomer to say the U.S. is dependent on foreigners, thinking that this must continue. If the private sector saves more, a larger percentage of government bonds will be bought with domestic savings. In Japan, interest rates did not spike when the government increased deficit spending for this very reason.

The only question we have to ask ourselves is whether we want to reduce debt by:

  1. The Liquidation Scenario. decreasing aggregate demand and precipitating a major depression in order to liquidate zombie companies and malinvestment. This would cause a massive wave of defaults and decrease debt burdens significantly through bankruptcy and debt repudiation. or;
  2. The Glide Path Solution. increasing aggregate demand by maintaining government spending while trying to liquidate zombie companies and malinvestment. This would allow the private sector to decrease debt burdens significantly over time through increased savings. It also has the benefit of reducing dependency on foreign sources of capital. The downside is a major increase in government debt, the spectre of big government and a long muddle through.

As I have said previously, the Obama Administration is doing neither of the above. It has opted for a third Herbert Hoover solution:

  • The Hoover Status Quo. decreasing aggregate demand and precipitating a double dip recession in order to reduce government deficits. This would cause a wave of defaults and decrease debt burdens through bankruptcy and debt repudiation. Meanwhile they will try to prop up zombie companies and maintain malinvestment. This would simultaneously prevent the private sector from decreasing debt burdens through increased savings and maintain dependency on foreign sources of capital – all without ending the spectre of big government.

I have advocated the glide path solution. But I see the liquidation scenario as much better than the present path – especially since, with the present course, we are witnessing crony capitalism on a massive scale. The problem with the liquidation scenario is a lower standard of living and the prospect of geopolitical tension, social unrest, poverty, and war.

The Herbert Hoover solution we are now using leads to a Japanese outcome at best or a Great Depression outcome at worst.

Obama: Debt Could Fuel ‘Double-Dip Recession’ – FOXNews.com

14 Comments
  1. LavrentiBeria says

    This guy is just a disaster. And you knew it before he was elected what with his obsequeous AIPAC speech and his assetion that the “surge” had worked. Soon he’ll have 40,000 more troops buthering kids in Afghanistan. But for now its his utter incompetence with economics. From the Summers/Geithner/Bernanke appointments to this lunacy on debt reduction over jobs, he’s setting up the circumstances for genuine political unrest in the very near future. One wonders whether Rosenberg would up his 13% unemployment prediction in light of this idiocy.

  2. Jo says

    I’d cut spending AND force The Liquidation Scenario.

    The ‘pain tomorrow’ scenario no longer cuts it.

  3. WPEconomy says

    This author is totally off-base. The analysis would be good (well-written for sure), if only its underlying assumption – that Obama is going to cut the deficit to avoid recession – were accurate at all. The author took one little snippet from an entire interview (FoxNews nonetheless – where you have to know Obama is going to say something different to appease right-wingers a little) where Obama said he worried about the deficit possibly causing another recession because of fears about the dollar.

    Did the author not read the rest of the article? Obama proceeded to talk about tax incentives for businesses and other stimulus-like measures. Obama has done ANYTHING BUT decrease aggregate demand. Remember, we had a several billion dollar stimulus earlier this year (albeit, it was a little smaller than I think was needed). And, if the author was paying attention to the news, rather than basing his or her entire analysis on a snippet, the author would know that a new jobs bill is likely around Christmas time or early next year. Obama, Harry Reid, and House Democrats started discourse on the jobs bill LAST WEEK. So, I just find this post uninformed and mostly irrelevant, however insightful and fruitful it would be if the assumptions were accurate.

    More here on jobs bill by Christmas at my blog: http://www.wpeconomy.com/2009/11/jobs-bill-legislation-by-christmas.html

  4. Joel says

    I think you need to take what he said with a grain of salt. Perhaps he was talking up the need to tackle the deficit to appease his major creditor. This seems more likely considering that he has been in China this week. Actions speak louder than words and as WPEconomy said, his actions have all spoken of increased deficits.

    Ed, thanks for your insightful posts and for this wonderful blog. It has become a daily read for me.

    1. Edward Harrison says

      Joel, you could be right. After all, we have seen Obama visit Japan and China in the past few days. Time will tell what policy is, but you have to worry whether the Administration understands we are in a very fragile economic state. reducing demand through higher taxes and/or spending cuts will certainly make things worse over the short-term.

  5. Scott says

    The reality is is that the man on the street does not manage his life with a stimulus package in mind. He manages his life with the money in his pockets and he is not comfortable with the fact that government spending redistributes income. Who cares if the government needs to pick up the slack to make up for a drop in consumption? I stopped consuming and money still gets taken away. That’s why these philosophical arguments are so misguided.

    I love your input and your analysis and this is not pointed at you, but all this “what we should do” just makes the “man on the street” feel insignificant. He’d rather have the money he made in his pocket. Obama is catering to tha sentament, regardless of a double dip because he is a politician that needs votes.

    Scott

  6. Anonymous says

    Well unless you advocate going back to the consumption binge during the housing bubble, you are crazy. That kind of economy is long gone since housing market has been destroyed. The consumer economy has reached it limits. It can’t consume without going into massive debt, like the consumption binge during the housing bubble. Stimulus doesn’t work. It takes ages for the money to be channeled through the gigantic bureaucracy, and as far as the bail outs, it only created zombie banks scared to lend probably for good reasons. Living on debt is unsustainable. What business, and the consumer want is stability in the economy, not stimulus. As for job creation, the size of the government is already 58% for all people who work for it, or dependent on it. It’s socialism that requires a lot of funding to keep it going. Of course you don’t want to end up like bankrupted countries in the EU like Greece which had it’s credit rating reduced. It’s not sustainable, because the US is soaking up all the world’s US dollars. It can’t keep adding more debt. The only other solution is print more money.

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