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How to Appease the Deficit Hawks Without Hurting the Economy

The Deficit Paradox

So despite the fact that Treasury markets are showing no signs of impending doom, many argue that we need to act in order to preempt a buyer’s strike of US government debt.  Deficit cutting is a dangerous path for our country to head down right now, as doing so leads to the shrinking of aggregate demand/GDP.  I went through this in my recent post on a Different Shade of Political Risk:

As Bill Gross astutely observed, “Tougher sovereign budgets produce government worker layoffs, pay cuts, reduced pension benefits and a drag on consumption and the ability of the private sector to accept an attempted hand-off from fiscal authorities. Recession becomes the fait accompli, and the deficit/GDP ratio moves ever higher because of skyrocketing risk premiums and a plunging GDP denominator.  In many cases therefore, it may not be possible for a country to escape a debt crisis by reducing deficits!” [emphasis Gross’]  While conventional wisdom may hold that reducing spending will close a deficit gap, reality has consistently demonstrated that reducing spending ultimately increases deficits.  Aggregate demand is equal to the sum of consumer expenditures + investment + government expenditures +/- the balance of trade (at the same time, ΔAD=ΔC+ΔI+ΔG+ΔBalance of Trade).  A drop in government spending triggers a drop in aggregate demand, which resultingly triggers a further drop in consumption and investment.

There are two ways for a country to make the deficit shrink as a percentage of GDP: one is to cut the deficit, the other is to increase the rate of GDP growth.  The quote from Bill Gross above is particularly apt, as Gross is a huge owner of US Treasuries, and as such, his words give us insight and perspective into what market participants really think.  Cutting deficits is a difficult paradox, in that doing so can lead to a drop in GDP and subsequently INCREASE the government’s deficit as a percentage of GDP.  I am utterly baffled at how many are calling for the immediate cutting of US government spending, while simultaneously calling for tax cuts, as if that is a solution to this problem (I’m looking at YOU Larry Kudlow…I can’t listen to the guy anymore).  This is especially true considering the budgetary troubles on the state level.

While cutting government spending would not be the best idea right now for the broader economy, there are two areas in which the government CAN cut spending without unleashing negative consequences on the economy at large, and possibly even helping the economy.  One such way is one of the most politically popular areas of the budget to cut (and something in which both Keynesians and Free-marketers alike agree should be cut) and the other is one which seems too politically taboo to even mention.  Let’s start with the popular–agricultural subsidies.

Agricultural Subsidies

As of 2009, agricultural subsidies in the US totaled $20 billion, or the rough equivalent of 0.5% of our entire federal budget.  While the percentage may sound small, that amount can have a major impact over the long run.   I propose to completely abolish agricultural subsides in this country altogether.

An Economist/YouGov poll from early April of 2010 found that aside for foreign aid (which is pathetically small in our country relative to other spending areas) and the environment (I guess people think we treat it well enough as is), agricultural subsidies were the component of our budget enjoying the most support for cuts (27% of Americans polled).  I am sure much of this has to do with the changing nature of agriculture in the country.  When these subsidies first began, we were largely an agrarian nation in which much of the population earned their livelihood via farming.  Today things are completely different.  In Making Globalization Work, Joseph Stiglitz offers the following statistical breakdown of the state of agricultural subsides in the US today:

…the vast bulk of the money goes to large farms , often corporate ones.  These subsidies have become simply another form of corporate welfare.  Looking across all crops, some 30,000 farms (1% of the total) receive almost 25% of the total amount spent, with an average of more than $1 million per farm.  Eighty-seven percent of the money goes to the top 20 percent of the farmers, each of whom receives on average almost $200,000.  By contrast, the 2,440,184 small farmers at the bottom–the true family farmers–get 13 percent of the total, less than $7,000 each.  The huge subsidies…actually drive out the small farmer.

Additionally, 90% of these subsidies are for staple crops, such as corn, wheat, soybeans and rice.  It is neither in our economic nor nutritional interest to focus so extensively on grain subsidization.  Besides, a large portion of the corn in this country isn’t even grown for food consumption purposes.  Ten million hectacres of arable land are used to grow corn for ethanol, adding up to a subsidy of $0.45 per gallon.  Ethanol is demonstrated to have only a marginal improvement in environmental efficiency at best, and this subsidization is leading to an economic inefficiency in our agricultural markets.  More land than would otherwise be used for corn is used for corn solely because of these subsidies. This cheapens corn relative to alternative edibles and drives up the price of other food staples, such as fruits and vegetables.

We hear many deficit hawks talk about the stimulus as “socialist” , deficit spending crowding out the private sector, and the inefficient allocation of capital from the public sector, yet very rarely do we hear anyone lambaste agricultural subsides.  Somehow health insurance for Americans is evil and un-American while agricultural subsidies are what exactly?

The Politically Unmentionable

Let’s end the wars in Iraq and Afghanistan.  Forget about the past debate.  With the benefit of hindsight, we know we went into Iraq for the wrong reasons and we still know of no “end-game” through which a “victory” can be achieved.  Not much more needs to be said here; however, one thing that is particularly interesting is that most people do not even realize that the wars in Iraq and Afghanistan are not accounted for in our regular budget.  Rather, wars receive special budgetary treatment.

Despite not being included in the regular budget, these wars have a major impact on our fiscal balance.  It would go a long way towards quelling any potential bond market jitters to make clear that an end is in site for these wars and that US dollars will stop going down this completely unrewarding sinkhole of simultaneous foreign quagmires.

Conclusion

If we cut both of these areas of our fiscal spending, not only can we appease deficit hawks, but as a country we might even have some more wiggle room for more stimulus.  Speaking of stimulus, should China actually let the Yuan rise relative to the dollar, they would be doing the US a major favor in stimulating the economy.  That is why market futures went up so much ahead over the weekend following the announcement.  It works like this: through all this time in pegging the Yuan to the dollar at an artificially low price, China has been accumulating a horde of US dollar reserves.

Effectively, this policy allowed the US to export inflation to China.  In allowing the Yuan to rise, China will slowly release some of these stored dollars into the global economy, ultimately providing a stimulant to global aggregate demand.  This is just what the doctor ordered at a time when it is needed most.  Let us just hope that China follows through on their promise, as this could help grow the US GDP, thus decreasing the fiscal deficit as a percentage of GDP.

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