- Reasons for asserting that the number one economic problem is the federal deficit
Large fiscal deficits in recent years have resulted in rising interest rates and as a result an increase in the cost of borrowing as creditors begins to doubt America’s ability to pay up its loans. High interest rates have also slowed down growth in key sectors like construction, banking and insurance making the journey to economic recovery a distant dream.
If the government goes on borrowing to cater for the fiscal deficit, it will drive up interest rates and this will compel private companies to battle with the government for investors. This will in turn reduce economic growth, potential earnings and eventually the standard of living will go down.
It will be a gradual process but it could be unfavourable if the would-be creditors lose confidence in the government to put its fiscal policy in order and decide to invest their money elsewhere.
The debt-to-GDP ratio is constantly rising and by the year 2020 it will be at 66%. In the worst case scenario, the ratio might be at 100% by 2020 according to the Congressional Budget Office. US debt is increasing rapidly and it is expected to reach 20.9 trillion dollars by 2017. Unless government spending is curbed and revenues increased as a share of GDP, growing fiscal deficits will rise to unimaginable levels in the medium-term.
- Outline the reasons why the deficit is not the problem but rather the depressed state of the economy and the long term unemployment.
Bush’s administration had introduced tax cuts mainly on the wealthy and funded two major wars. The government ran major deficits for seven straight years and was on the brink of an economic meltdown. As Bush’s administration was coming to an end he instituted major spending cuts which spilled into Obama’s administration. By 2009, the fiscal deficit had reached more than 1 trillion dollars. The government spent hundreds of billions of dollars to bail out big firms including banks, insurance companies and car manufacturers in a bid to stimulate the economy. This slowed down job losses and some growth was realised. In the 3rd quarter of 2009 the economy grew by 2.2% and in the fourth quarter it grew by 5.7%, a fete few people thought was possible a year back.
However, without a major jobs revival strategy to increase consumer spending and fiscal receipts, the country might face deficits in the short-term. Economic growth will be very slow in the coming years.
The government’s move to spend 266 billion dollars on tax credits for hiring and job creation investments along with other stimuli would help to improve the deficit. The proponents of this move support increased investment in education and infrastructure to stimulate economic growth.
Chances of a renewed fiscal expansion have almost faded away with the Federal Reserve being quoted as too cautious signalling a long period of weak economic growth and a high unemployment rate.
- Evaluate both explanations.
According to Lord Keynes, in a recession consumers and businesses are too afraid and broke to spend and invest. Therefore, it is up to the government to spend and invest in huge public works projects and short-term tax cuts. It’s based on this theory that the Congress and the White House enacted the American Reinvestment and Recovery Act in 2009. This Act allocated 787billion dollars to a range of stimulus programs to boost the economy. Obama’s administration has since then supported increased spending measures by the government as opposed to huge budget cuts (that Republicans have argued is the way forward) to prevent the economy from entering into recession.
According to Hayek, the government does not have money to spend unless it diverts it from other uses. He said that prosperity arises from economic growth due to new wealth rather than redistribution of the existing wealth. Such redistributions are ineffective because they undermine the ability to produce new wealth and he termed such distributions as illegal and immoral. These sentiments agree with Frederic Bastiat’s hypothesis in his essay “The Seen and the Unseen” 160 years ago. Some economists have come out strongly condemning the government’s move to increase spending arguing that such money has been diverted from other sectors of the economy and the overall “increased spending” would not have the desired effect on the economy.
- Evaluate the effectiveness of the fiscal and monetary policies that have been pursued in the light of growth, employment and inflation.
The fiscal policies adopted in the last few months of the Bush administration and the first few months of the Obama administration have, according to Alan Binder, the former vice-chairman of the Federal Reserve, been successful. According to him the Federal Reserve uses a standard macro-economic model in order to assess the consequences of no intervention, both fiscal and monetary, from the government. If no fiscal intervention had been made in 2009, the peak to trough decline in GDP would have been 12% compared to the 4% decline after intervention. If no intervention was made, the unemployment rate would have reached a high of 16.5% whereas currently it stands at 10% due to the intervention. Lack of the fiscal intervention would have meant a fiscal deficit of about 2.6 trillion dollars in the fiscal year 2011. Better results would have however been obtained if there was more of financial policy response and less fiscal policy response.
Compared to other first world countries, the recession in output in the US has been small. Unemployment, however, has substantially increased due to an increase in the country’s productivity. It has also been attributed partly to the slowdown in the construction industry. The rise in unemployment has also been attributed to the ease of laying off workers in the country. Experts suggest a review of existing laws to make it harder for employers to lay off workers.
Monetary and fiscal intervention have direct impact on demand and output and judging from the relatively small decline in output and the fact that the US was the epicentre of the global financial crisis, the intervention has been a success.
Some quarters like the Panglossians, however, disagree with the modest stimulus package that was introduced. They argue that the idea of permitting the collapse of most of the financial system, trying to close the fiscal deficit and avoiding irrational monetary policy is absurd.
In 1957, Milton Friedman wrote that attempts to boost consumer demand through government spending are futile and would not result in anything. The reason for this was that individuals decide on consumption by considering their likely income and wealth in the future. He termed this as the “permanent income hypothesis”. If the government spends huge amounts of money today, individuals will foresee higher tax rates and as a result their lifetime incomes will decrease due to the increased tax. If the stimulus program is indeed a short term measure or a one-time intervention strategy, consumers would look at it in a more positive light. However, the 2009 stimulus program did not occur in a vacuum and rather it took place amidst a lot of speculation and poor trading. It was accompanied by other policies and proposals which contributed to the overall its failure. These proposals included defence spending cuts, funding for research and development in to cleaner sources of energy and healthcare reforms.
Comprehensive tax reforms are also vital for the government’s expenditure to match the revenue. For the last thirty years, revenues from tax have averaged 18.4% of the economy. On average, expenditure other than servicing debt is expected to rise from 19.2% of the current economy to over 25% in 2050. It this therefore important that tax reforms be put in place to curb the rising fiscal deficit. Obama’s administration has been reluctant to increase taxes especially on those earning less than 250 thousand dollars. Other lawmakers have called for tax-cuts which will only increase the fiscal deficit to unimaginable levels in the medium-term. With healthcare reforms set to come in place, the hope is this will create new tax avenues thus broadening the tax base. It would eventually lead to increased revenue streams to offset government expenditure.
Work Cited
Bivens J., Fieldhouse A. & Shierholz H., “From free-fall to stagnation: Five years after the start of the Great Recession, extraordinary policy measures are still needed, but are not forthcoming”, Economic Policy Institute February 14, 2013.http://www.epi.org/publication/bp355-five-years-after-start-of-great-recession/ (September 24, 2013).
Riedl, B., “Why Government Spending Does Not Stimulate Economic Growth: Answering the Critics (2010)”, The Heritage Foundation January 5, 2010. http://www.heritage.org/research/reports/2010/01/why-government-spending-does-not-stimulate-economic-growth-answering-the-critics(September 24, 2013).
Wapshott N., “The Keynes-Hayek showdown”, Reuters November 7, 2011. http://blogs.reuters.com/great-debate/2011/11/07/the-keynes-hayek-showdown/(September 24, 2013).
