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THE JETHRO PROJECT
O R G A N I Z I N G F O R E F F I C I E N T O U T P U T
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The Republican/Tea party often drives the political narrative, and Democrats follow. The existing narrative is budget deficit reduction, which the Democrats are co-opting. But, is it wise to reduce government spending in a weak economy and rising crude oil prices?
The government budget surplus (BuS) or deficit (DF) is the difference between tax revenues (T) and government expenditures (G + R). It can be represented by the following equation: BuS = T – (G + R), where T (= tY) is the tax rate (t) times income (Y), G is government spending and R is government transfers.
Thus, given a tax rate, t, and fixed government outlays, G and R, the budget is a function of income (Y) or gross domestic product (GDP). Therefore, when GDP increases, government revenue (T) increases. Conversely, in poor economic times, when GDP is low, government revenue decreases and a budget deficit is likely to occur.
According to Robert Barro, sustained economic growth is possible only within a sound macroeconomics framework; in such a framework fiscal and monetary policies play critical roles.
Policy makers are elected to implement sound macroeconomic policies that lead to full employment. Unfortunately, they have failed to do so.
Had voters elected legislators with appropriate macroeconomic know-how, they would have been able to foresee the degradation of the economy. Likewise, they would have implemented policies to mitigate the effects of internal (illiquidity) and external (rising crude oil prices) economic shocks. Furthermore, even if they missed the downturn, they should be able to implement policies that accelerate economic growth and employment.
Instead of facilitating full employment, politicians cling to the narrative of deficit reduction. However, reducing government spending (the budget deficit) in a slow economy and rising oil prices will adversely affect GDP and hence employment.
The graph below shows the effect of reducing government and transfer spending on income or GDP.
As can be seen, reducing government spending from (G + R)0 to (G + R)1 shifts the government budget curve upwards from BuS0 to BuS1 and reduces income from (G + R)0/t to (G + R)1/t, and hence employment. To return to (G + R)0/t, the tax rate would have to be reduced. However, reducing the tax rate reduces revenue, leading to further increases in the deficit.
The lack of a job growth strategy and the focus on deficit reduction, when crude oil prices are increasing and banks are not expanding the money supply, is indicative of a dysfunctional government. Expansion of bank lending is necessary to create economic growth and full employment.
Obama’s relentless goal should have been achieving a full employment economy. He and the Democrats should refuse to be caught in the Republican/Tea party narrative of budget reduction in an anemic economic recovery.
However, too often, Obama and the Democrats have allowed the Republicans to drive the political narrative. They should revisit the Kennedy and Johnson administrations 1960’s strategies, where activist economic policies where used to restore full employment. The Kennedy and Johnson economic policies led to the great expansion of the 60’s.
During that period, the Council of Economic Advisers (CEA) focused on attaining full employment. And, in conjunction with Arthur Okum, the CEA developed the concept of potential output.
Potential or full employment output measures the level of real GDP required to produce full employment.
The CEA understood that employment could be increased through aggressive expansionary fiscal and monetary policies. It also understood that doing so could create inflation.
Therefore, it established guideposts for the behavior of money wages, where money wages would not grow faster than the average rate of productivity.
Today’s policy makers only pay lip services to job creation. Apparently, they are not concerned with the well being of constituents. They have had over two years to remedy Bush’s economic wreck and to facilitate the process of job creation, but have failed to do so.
And now, both parties are hitched to the deficit narrative, mainly to detract attention from their inability to facilitate full employment.
If policy makers understood how to facilitate full employment, income, employment and tax revenues would increase and the deficit would fall.
They fail to understand that in a monetary economy the availability of money, through credit, allows for economic expansion. And, that when banks restrict credit, they restrict economic expansion.
The administration and legislators should use the Federal Reserve to facilitate commercial bank credit expansion for small business and consumer purchases. Additionally, when the price of crude oil is unstable, they should work to reduce Middle East conflicts and to set up a mechanism to suspend futures crude oil trading when there is regional instability in crude producing regions. Otherwise, the economy will remain stagnant.
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