The fiscal cliff, Okun’s law and the Long Depression

President Obama and the Republican-held US House of Representatives are locked in a battle to find a way to overcome what has been called ‘the fiscal cliff’ that the US economy faces in the New year. The fiscal cliff describes the automatic rise in various taxes and reductions in government spending that will be applied from the beginning of 2013.

This is going to happen because there is a range of tax cuts and exemptions that the Bush administration introduced as ‘temporary’ measures and were designed to expire each year unless Congress renewed them. And there are other measures like exemptions from social security taxes for employers in order to keep people at work that also expire, as well as agreed automatic cuts in spending that will be imposed if the President and Congress cannot agree on a plan to control spending and reduce government debt for the rest of this decade.

If the fiscal cliff comes into play, it is estimated that it will cause a net increase and taxes and reductions in spending worth over $600bn, or 4% of annual GDP. The fear is that this is such a large hit to an economy growing at only 2% a year in real terms that, if allowed to take place, the US economy will be driven back into recession.

What is bad news for the average American household is that both the President and the Congress agree that the government’s annual deficit of spending over revenue and the level of federal government debt must be reduced. The difference between them is only over whether that should be done mainly by tax rises or spending cuts.

But even here the difference is minimal: the President does not want the expiring tax cuts to be renewed for those earning more than $250,000 a year while the Republicans want the tax cut to be renewed for all. This makes very little difference to the overall budget saving. It is really aimed at showing an electorate that has just returned Obama to office on a mandate to maintain key government services and make the very rich pay a fairer share that he will keep that promise.

Yet removing the Bush tax rate cuts for those earning over $250k a year affects no more than the top 2% of taxpayers. The most likely compromise is around $500k. So no more than the top1% will pay more in 2013 than they did in 2012.

Ironically, the Obama administration is proposing a long term budget plan that will mean a larger reduction in the deficit by 2020 than the Republican proposals! That’s because, although the Republicans want larger cuts in government spending, they want much lower tax increases. So, as under previous Republican presidents Reagan and Bush, the budget deficits would be higher than they were under Clinton or would be under Obama.

The Republicans want to decimate the main government welfare programmes, the so-called entitlement programmes of Medicare, medicaid and unemployment and social security benefits. These are already insufficient to meet the needs of America’s growing poor, disabled and elderly. Even so, they would save less than Obama plans because the Republicans don’t want to cut defence and home security spending.

The Obama proposals protect entitlement programmes and instead propose significant reductions in services in so-called discretionary spending like education, defence and general services like national parks, environment etc. For example, mental health services have been slashed under previous administrations and, as a result, seriously ill and dangerous people are carrying out more acts of mayhem like the Connecticut school massacre. And yet both sides plan more cuts in federal spending in these areas, while state budgets have already been annihilated.

Discretionary spending by the federal government is now at an all-time low and is set to go further. It will mean that the federal government will not deliver decent public services for Americans in this decade and beyond. It recalls the famous aphorism of radical Keynesian economist JK Galbraith of 1960s America’s ‘private affluence and public squalor’. Only now, even private affluence has dissipated for most Americans.

A shoddy compromise will be reached between Obama and Congress that will leave America’s pensioners, disabled, sick, unemployed and working poor worse off through this decade. So it was disturbing to read in Paul Krugman’s NY Times column that he was agonising over whether Obama should accept a deal that ‘protects’ Medicare and social security payments at the price of reducing the protection of pensions and tax thresholds from annual inflation by switching the indexing from the consumer price index (CPI-U) to what is called the chained index (C-CPI-U).

U stands for urban consumers, 87% of Americans. The chained index has risen more slowly than the standard index because it tries to account for substitution of cheaper alternatives in the shopping basket. The impact of using the chained CPI would be to reduce annual increases in pensions and tax thresholds by 5% over 12 years, hitting living standards for average American households six times more than the rich. Over a course of an average retirement, future pensions would be reduced by 10%.

Some Keynesians appear ready to take this shoddy deal. Moreover, as Democrat economist Larry Summers revealed in a recent article in the FT, they do not even advocate a proper progressive income tax system where you pay a higher rate as your income rises or increased corporate tax, now at it lowest since 1945. Summers merely wants to tax inherited wealth a bit more and close various tax avoidance loopholes. None of these measures would help provide sufficient revenue to preserve government services or deliver greater ‘fairness’. (see How to fix a costly and unjust tax system, FT 16 December 2012)

And the debate between Obama and the Republicans over how to reduce government spending and debt has nothing to say on how to get the US economy growing faster and unemployment down. The sad truth is that if the US economy could expand in real terms by 3-4% over the rest of this decade, the government deficit would narrow and debt would stop rising as a share of GDP enough to sustain pensions and Medicare in real terms and avoid the fiscal cliff. But there are no proposals on how to do that.

Federal Reserve Chairman Ben Bernanke, now safe in his job after Obama’s election victory, has pushed on with a new programme of quantitative easing (QE) by intending to buy more government and mortgage bonds until unemployment falls from its current 7.9% rate to 6.5%. The Fed’s own estimates reckon that this would not be achieved until mid-2015, given weak economic growth. But even 6.5% would be a much higher rate than existed prior to the crisis in 2007, which never rose above 5%. To achieve even 6.5% by 2015 would require that the average job growth of the last year of 220k a month is sustained. If that monthly rate fell to 150K, the 6.5% target would not be met until 2018! Either way, US capitalism cannot restore employment to pre-crisis levels for the foreseeable future.

Okun’s law argues for the obvious relationship between real GDP growth and employment growth. A new paper finds that since the exit from the Great Recession, there appears to be a change in the relationship from prior to the crisis. Employment is currently 2.7% below where it should be. This is further proof that we are in a Long Depression different from normal slumps since the 1960s. There has been a permanent change in the magnitudes of Okun’s law for the US and it seems that 3m jobs have been lost forever. (Ferrara and Mignon, An assessment of the US jobless recovery through a non-linear Okun’s law).

Neither Monetarist nor Keynesian measures have provided solutions that raise the growth rate or restored employment back to pre-crisis levels. As a result, the austerity measures that are planned in any agreement on the fiscal cliff will not stop the government debt ratio rising – the purpose of the fiscal cliff.

The fiscal cliff is not some shock to the economy outside the control of policy makers. The decision to impose automatic spending cuts and tax rises is that of politicians, both Republicans and Democrats. There is no need to do it or introduce any further reductions in the real incomes of average households and public services.

As mainstream economist, turned radical, Jeffrey Sachs, put it in a recent article in the FT (Today’s challenges go beyond Keynes, 17 December 2012), “Unlike the Keynesian model that assumes a stable growth path hit by temporary shocks, our real challenge is that the growth path itself needs to be very different from even the recent past.”

Such a growth path requires a sharp rise in investment and a long-term strategy, says Sachs. He decries the failure to produce such a strategy by America’s political elite and argues for cooperation between government and the capitalist sector to do it. But while the profitability of investment in the productive capitalist sector decides employment and incomes of the majority, the Long Depression will continue until profitability rises sufficiently. So Sachs’ proposal is just as utopian as monetarist or Keynesian solutions to the current Long Depression.

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3 Responses to “The fiscal cliff, Okun’s law and the Long Depression”

  1. Hedlund Says:

    Not related to this post, but something I’ve been wondering for a while: Has Peter Jones released any documents further expounding his alternative approach to measuring the rate of profit (contra both current- and historical-cost accounting methods) referenced in that paper of his you linked some months ago? Also, has Kliman, Freeman, or any other TSSI proponent offered thoughts on said paper?

    • michael roberts Says:

      Hedlund
      Peter has not done a new paper as far as I know. AK does not agree with it at least that was my impression in a brief conversation with him. But I don’t know the reasons. G carchedi has been looking at it and I await his comments.

  2. Prasenjit Biswas Says:

    The connection between profit, growth of employment and public expenditure is not so obvious. One must rather have a mix between rising public expenditure by budget and non-budget means and long-term investment. Public expenditure can create those opportunities of long-term investment. In order to do so, thre needs to be public pessure on the politicians on welfare measures such as pension, grant-in-aid, loans for investment by small and medium investors in sectors such as infrastructure, eductaion and healthcare. This is a proposal for policy reorientation beyond a wall street controlled federal reserve.

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