Alan S. Blinder, a Princeton economics professor and former vice chairman of the Federal Reserve, contributed a guest editorial to the July 8 Wall Street Journal entitled "The Economy Needs More Spending Now." Since Blinder is a moderate, his views are a refreshing contrast to the ultra-right-wing rants that generally fill the editorial pages of that august journal.
Blinder says that besides politics, the chief cause of our economic policy failures is the failure to distinguish between short-term problems and long-term problems. Different ailments require different prescriptions. The medicine for short-term problems, used in isolation, could make our long-term problems worse. But trying to apply long-term remedies in the short-run will only cripple the economy such that no long term goals are accomplished anyway.
The problem with the American economy right now is a short-term problem---lack of spending. The only remedy is to increase spending. This could be done by either increasing government spending at all levels, lowering taxes on working people so that they have more to spend, or giving investment tax credits to manufacturers so that they buy more equipment, etc. This is what "The Stimulus" did, and it worked. The GDP would be at least 2 percentage points lower had this not been done. And if "The Stimulus" had been twice as large, we would have gained an additional 2 points, and by now we would have full employment. Everyone in Congress knew this.
So why didn't we pass a large enough stimulus to do the job? Because everyone in Congress was also worried about our long-term problem, which is our accumulating national debt. The Clinton administration had left a balanced budget, but Bush began his administration with a huge tax cut, and then went on to fight two wars without increasing taxes to pay for them. So when the market crash came in 2008, many in government felt that they had very little room to maneuver, since they felt that we were already drowning in debt. Yet if they had passed a large enough stimulus, everyone would now have a full time job, social expenditures would be lower, and the increased tax collections from wages would easily balance the budget. But instead of fixing our short-term problem, we tried to use austerity to fix the long-term problem first. This is like letting the accident victim bleed to death while carefully building the perfect cast to put on the broken bones. Blinder explains the difference between short-term and long- term solutions as the difference between demand-side and supply-side solutions. He writes:
"Long-run growth is supply-determined: it depends on the economy's ability to produce more goods and services from one year to the next. To accomplish that you need four basic ingredients: more labor, more capital, better technology, and--if you can manage it--a better-functioning economy that utilizes these inputs more efficiently. These four ingredients constitute the essential core of supply-side economics, and deficit reduction helps boost growth via the second: more capital.
In the short-run, however, output is demand-determined. The big question is how much of the economy's productive capacity is used. And that depends on the strength of demand----the willingness of businesses, consumers, foreign customers and governments to buy what American businesses are able to produce. When demand falls short of supply, deficit reduction hampers economic growth by reducing demand even further. " (Emphasis mine)
Blinder explains that a society can increase capacity by building more plant and equipment and training more workers, but if there is insufficient demand, all that new capacity would just sit idle. This is about what has happened since the beginning of the Great Recession. Blinder says that we must treat both the long-term and the short-term problems. To do this, we should not try to aggressively cut spending now, while the economy is weak and needs all the spending it can get. Instead, we should spend aggressively today to end the recession, while passing laws today that will cut the deficit, but take effect only several years down the road, when the economy is fully recovered. While Blinder asserts that deficit reduction today simply makes the recession worse by dampening demand, he does not go into much detail as to how it does this. Some months ago, I posted on this blog an essay entitled, "Why Supply Side Economics Doesn't Work, " in which this is explained. Check it out.
While Blinder's remarks were addressed to the problems of the American economy, they would be even more applicable to the problems of the Europeans, who have used austerity even more foolishly than we Americans have.