Explaining Southern California's economy

Visual Aid: Why fiscal responsibility may cost the U.S. money

The above chart is from the U.S Treasury's Treasury Notes blog (Cute, right?). It was written by Jan Eberly, who argues that this is not a good time to be pulling back on support for the economy, even though we're running up some significant deficits in the aftermath of the financial crisis. 

What it all boils down to is a question about what we should do in the short term:

While there is a nearly complete consensus among economists and budget analysts that deficit reduction sufficient to stabilize our debt would have significant long-run economic benefits, the literature also cautions that fiscal consolidation is contractionary in the short run. Though under certain conditions the withdrawal of fiscal support can be partially offset by economic and policy changes, those conditions do not prevail in the United States today. Interest rates are currently at historic lows, leaving little room for them to go lower, and though exports have grown at a healthy pace recently, they cannot be counted on to grow enough to offset substantial near-term cuts.

Think about that. We've been getting an nice GDP bump from exports, which have been made more appealing by a weak U.S. dollar. But trade ebbs and flows, and we do need to remember that Europe, now in the throes of a financial crisis of its own, is our biggest export market. 

Also, the Federal Reserve has nowhere to go with monetary policy, on the interest-rates front. They are indeed at historic lows. The Fed may have a few more policy tricks up its pinstriped sleeve, but if government spending is cut, the Fed can't make money much cheaper as a means of stimulus. 

On the treasuries front, yields on 10-year bonds have been hanging around 2 percent, ironically, since S&P downgraded the U.S. from an AAA to an AA+ rating. We could bring on fiscal austerity to attack the deficits, but as Eberly points out, it's hard to see how that would be able to somehow push yields lower. 

People are investing in the U.S. to keep their money safe in a chaotic world. But they don't want to loan us money for ten years for a completely negligible return. There's safety and then there's stupidity.

As the chart shows, the difference between actual and potential GDP fell of cliff when the financial crisis hit and hasn't edged back into even the modest positive territory is last saw in the mid-2005-to-mid-2007 period. In fact, the differential is now widening, so if short-term action isn't taken to solve that problem, it may take that much longer for the blue line to catch up to the red line.

In a nutshell, the real deficit to be worried about, short-term, is the one we're running in potential GDP. That gain is slipping away. And you could certainly argue that if we don't spend the money now, in a time of low interest rates, is will be expensive to buy it back, when interest rates have crept back up. 

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