George H. Blackford, Ph.D.

 Economist at Large

 Email: george(at)


It ain't what you don't know that gets you into trouble.

Itís what you know for sure that just ain't so.
Attributed to Mark Twain (among others)


Economic Papers
Political Essays

A Primer on Economic Crises

Part IV: The Challenge Ahead

George H. Blackford © 2008/9


It is well known, even to Republican politicians, that the government can use its tax and expenditure policies (i.e. its fiscal policy) to stimulate the economic system during periods of high unemployment. 


How Fiscal Policy Works

When the government increases its expenditures on goods and services during these periods there is an increase in income (and employment) in the economy as a whole.  Whatís more, this increase in income will be greater than the increase in government expenditures.  The reason is a portion of the income received by those who sell directly to the government as a result of the increase in government expenditures is used to purchase consumer goods that otherwise would not have been produced and sold.  As a result, producers of these consumer goods see an increase in income that is an indirect effect of the increase in government expenditures.  This secondary effect on income has a tertiary effect as a portion of the secondary increase in income in the consumer goods industries is spent on additional consumer goods leading to a further increase in income for the producers of consumer goods as even more consumer goods are produced and sold.   As this process works itself out there is a multiplier effect of government expenditures that increases income (and output and employment) in the economy by two or three times the initial increase in government expenditures. 


A similar process works itself out when the government cuts taxes.  A portion of the increase in after tax income that results from the tax cut is spent on consumer goods that would not have been produced and sold otherwise and thereby there is a secondary effect on income in the consumer goods industries.  This process works itself out the same as when there is an increase in government expenditures, the only difference being the entire process is indirect since the initial increase in after tax income did not directly increase output.  Thus, there is a multiplier effect of tax cuts on income (and output and employment), just as there is a multiplier effect of government expenditures on income (and output and employment).  This effect is less for taxes than for expenditures because the effect of a tax cut is all indirect, but there is some effect just the same. 


Fiscal Policy, Deficits, and the National Debt

The government can use its tax and expenditure policies to minimize the effects of the coming recession, but only by borrowing the difference between what it receives in tax receipts and what it pays out in expenditures.  This difference is referred to as the deficit, and the deficit is the amount by which the National Debt increases each year.  This debt must be managed, and given the irresponsible management of the National Debt during the Reagan and two Bush administrations, it must be managed well in the coming months and years if we are to avoid an international economic catastrophe far beyond the catastrophe we see today. 


In 1980 Reagan inherited a National Debt of $909 billion ($0.91 trillion) that was equal to 33% of Gross Domestic Product (GDP).  At the end of the Bush I Administration that debt had increased to $4.0 trillion and was equal to 64% of GDP.  During the Clinton years the National Debt grew to $5.6 trillion, but the deficit was turned into a surplus, and the ratio of debt to GDP fell to 58%.  Then came Bush II and the National Debt increased to $9.7 trillion, and the ratio National Debt to GDP went up to 67%.   Furthermore, this was accomplished by Bush II before the financial crisis began and the trillion dollar deficit created by this crisis came into being.  (BEA)


The end result of the Reagan/Bush administrations is a greater than tenfold increase in the National Debt, but what is more disturbing is the more than doubling of the National Debt to GDP ratio.  This more than doubling is disturbing because the government must pay interest on the National Debt, and GDP is directly related to the governmentís ability to pay this interest.  (BEA)


Today (November, 2008) we are facing a National Debt approaching $11 trillion and a debt to GDP ratio approaching 80%.  Currently the government pays approximately 4% interest on the National Debt.  If the rate of interest the government pays stays at 4% the amount of interest the government will have to pay in 2009 will be over $440 billion.  If the interest rate were to increase to 6% or if the debt were to increase to $16.5 trillion or if there were any combination of these two increases the bill would increase to $660 billion.  This would exceed the amount we are currently spending on any other item in the Federal Budget: more than Medicare ($396 billion), National Defense ($607 billion), and more than Social Security ($615 Billion).  (OMB)  Whatís more, it is virtually inevitable that interest rates will rise as the National Debt increases, and we begin to pull out of this recession.


As the ratio of National Debt to GDP increases it becomes more difficult to pay the interest on this debt since the GDP is a major portion of the tax base available to pay this interest.  The danger is the debt will get out of control and its growth will become explosive.  If this were to happen there would be a tremendous buildup of inflationary pressure in the economy that could lead to increases in prices that would lead to increases in interest rates that would add to the inflationary pressure.  This kind of inflationary cycle in the midst of a worldwide financial crisis and worldwide recession could lead to a lack of confidence in the Fed and the Treasury.  These two financial institutions lie at the center of the international exchange system by which international trade and capital flows are financed. 


Foreign central banks and other foreign financial institutions hold huge amounts of US Dollars and Treasury securities that provide the international reserves used to clear international transactions throughout the world.  A flight from the Dollar caused by a loss in confidence in the Fed and Treasury would lead to a precipitous fall in the value of the Dollar accompanied by a precipitous increase in interest rates and a collapse in the international exchange system throughout the world. 


Coping with the National Debt

Managing the National Debt in the face of the developing recession is the most important challenge we face today.  The reckless borrow and spend debt management concept that has stood at the center of Republican economic policy for the last thirty years must come to an end.  If this debt grows out of control it will break the Federal budget as interest payments become a larger and larger proportion of government expenditures, and it will become more and more difficult to finance government programs.  This means that in financing a financial bailout and an economic stimulus package we must be guided by two fundamental principles: 

  1. The first is with regard to expenditures by the government that do not involve an investment in the economy designed to increase economic productivity and growth in the future.  Here we are talking about increases in unemployment insurance, food stamps, the earned income tax credit, welfare expenditures, Medicaid, and the government expenditures used to bailout financial institutions.  These kinds of non-investment government expenditures must be financed as much as possible through increases in taxes.  At the very least taxes should be increased to the point where we can sustain a government budget without a deficit when the economy is at full employment.    

  2. The second is with regard to expenditures that involve an investment in the economy designed to increase economic productivity and growth in the future.  Here we are talking about increases in expenditures on transportation, communications systems, water systems, sewer systems, and other kinds of investment in our public infrastructure as well as investments our public educational system through construction and renovation of buildings, subsidizing student loans and grants, and through increasing expenditures on scientific research, both in the area of pure research and research devoted to sources of alternative energy and other areas that are consistent with our national priorities.  These kinds of government investment, and, to the extent possible, only these kinds of expenditures should be financed through increases in debt. 

It may seem counter intuitive to hear that we must increase taxes as we head into a recession, but the fact is taxes are too low in the United States for us to be able to sustain the kind of debt we are likely to incur in the troubled times ahead without putting the Federal budget at risk.  Given the totally irresponsible mismanagement of the National Debt on the part of the Reagan and Bush administrations if we donít do this it is likely we will find ourselves in a situation where the primary function of the Federal government will be to service the National Debt, and there will be very little left over to provide for other government functions.


If we were to follow the Japanese example where National Debt reached 165% of the Japanese GDP in 2008 (Martenson) we would end up paying well over $1 trillion a year in interest to service the National Debt even if the rate of interest the government has to pay were to stay at 4%, and there is no reason to believe the rate of interest will stay this low.  In fact, as was noted above, it is virtually inevitable interest rates will rise as the National Debt increases, and we begin to pull out of this recession.  (Bradsher Reinhart)  What would an interest payment of this magnitude portend for the ability of government to function in the future, to finance Social Security or Medicare or National Defense, if we were to follow this course?  (N Klein)


From a stimulus point of view, financing non-investment government expenditures with tax increases has at worse a neutral effect.  It will probably stimulate the economy, but in either event it strengthens the governmentís ability to manage its debt, and it will help to maintain international confidence in the Dollar. 


For the last thirty years we have been listening to the Republican mantra that government is the problem and all we have to do is deregulate the economy, cut taxes, and everything will be wonderful.  Given the mess following this mantra has created it should be obvious government is not the problem.  Toxic government is the problem, and the Republican idea that we can have good government without paying for it is the height of folly.  Taxes must be increased.


If we wish to live in a civil society with a functioning criminal justice system, a nonpoisonous environment, a stable economy, an educational system actually educates our children, an integrated transportation system, a comprehensive health care system, an effective National Defense, Social Security, Medicare and other social-insurance programs we must be willing to pay for these things.  The way these things are paid for is through taxes.  If we arenít willing to pay the requisite taxes to achieve the kind of society in which we wish to live, we are going to end up with a government whose primary function is to service the National Debt and virtually all else will go wanting.  (N Klein)


A Final Comment on Wealth Transfers

 Even though we have used an example of wealth transfers that resulted from the price rise and fall of a $100,000 house, we are not talking about hundreds of thousands of dollars here.  We are talking about trillions of dollars of transfers that took place during the housing bubble that burst in 2007 and its subsequent collapse.  Whatís more, the housing bubble fueled a bubble in the stock market as well.  The combined value of both financial and nonfinancial assets owned by households increased by some $22 trillion from 2002 through 2007 and then fell by $11 trillion by the end of 2008óan increase in total wealth of more than fifty percent from 2002 through 2007 and a drop of more than twenty percent in the single year 2008 that wiped out half of the increase since 2002.  (FRThis kind of volatility in wealth and the wealth transfers that result are extremely disturbing to those who play by the rules and are taken by surprise when they lose the wealth they thought they had.  The result is the kind of anger that undermines the very fabric that holds society together. 


The greatest gainers from these two speculative bubbles were those who purchased stocks and real estate at the beginning of the bubbles and sold toward the end, the mortgage originators who made billions creating the toxic mortgages that fueled these bubbles, the securitizers who made billions securitizing toxic mortgages and selling them to unsuspecting investors, and the owners and managers of financial institutions that created this mess and are being bailed out by the government.  The greatest losers are those who purchased stocks and real estate toward the end of the bubbles and taxpayers to the extent that the government must increase taxes or debt or cut back government services to bail out the financial institutions. 


In addition, even those who owned stocks and houses throughout this period and did not buy or sell with an eye to making a speculative profit feel cheated.  Even though the wealth they thought they had Ďearnedí by virtue of the increase in the value of their houses and financial assets during the boom was ethereal, and they may appear no worse off than if the speculative bubbles had not occurred, they are worse off to the extent the illusion of wealth at the top of the bubble allowed them to arrange their lives and plan their futures on the basis of this illusion.  When the bubble burst their lives and plans were disrupted in ways that would not have occurred if there had been no bubble.


Whatís more, this is not a zero sum game where one personís gain is equal to anotherís loss.  As this crisis turns into a recession there is a net loss to society as a whole.  The major source of wealth for most people is their human capital as determined by their earning power.  For most people simply being employed during a recession is potentially a gain as asset prices fall, but for those who lose their jobs the loss in wealth from the fall in the value of their human capital is devastating.  The same is true for most business owners:  Simply staying in business during a recession may lead to a gain as competitors fail, but for those who lose their businesses the loss in wealth is devastating.  The losses in wealth by the unemployed and bankrupt business owners are much greater than the gains of the survivors since these losses are accompanied by a fall in the total output of goods and services available to society as a whole.  These losses are measured in terms of real investments forgone and reduced productivity in the future; food, clothing, and shelter not produced; and ultimately in the homeless not sheltered, the sick not treated, and the hungry not fed. 


Finally, it should be noted the story of wealth transfers created by the government bailout of financial institutions does not end with the abstract notion that these government induced transfers are from taxpayers.  It makes a huge difference which members of our society these transfers are from: 


If these transfers are financed by the government by issuing government debt they are from our children and grandchildren to the wealthiest members of our society. 


If these transfers are financed through cutbacks in social programs such as food stamps, welfare, public education, Social Security, Medicare, Medicaid, unemployment compensation, a national health insurance program, the earned income tax credit or by increasing sales taxes, excise taxes, user taxes and fees, and increasing tax rates on lower and middle-income taxpayers the net result will be huge transfers of wealth from the poorest and moderately well off members of our society to the wealthiest members of our society. 


By the same token, if these transfers are financed by increasing the highest marginal tax rates, cutting back on corporate subsidies, enacting a financial transaction tax, and increasing the capital gains tax the net result will be huge transfers of wealth from the wealthiest members of our society to the wealthiest members of our societyóthat is, among the wealthiest members of our society. 


Needless to say, this last financing option is the one least favored by those who profited from the housing bubble and the subsequent collapse of the financial system since it is the only option that puts at risk the speculative profits and incomes they gained from this bubble.  The only thing that could make it worse is if an increased in the estate tax was added to this mix so they cannot pass their windfall gains on to their heirs.  This is the course we should follow as we attempt to recover from this crisis.  To those who complain that following this course is class warfare, I can only respond call it what you will, it is the economically sound thing to do, it is the right thing to do, and it is the only fair thing to do.  After all, how did we get in this mess in the first place? 


Over the last thirty years we have cut income and capital gains and estate taxes paid by the wealthiest members of our society; increased sales taxes, excises taxes, and user fees paid by the least well off members of members of our society; and cut back on government programs that serve the lower and middle-income earners in our society.  At the same time we have deregulated both the real and financial sectors of the economy; refused to enforce the Sherman Antitrust Act to the effect of increasing the concentration of economic power in almost every sector of the economy; eliminated usury laws and allowed credit card companies to change our bankruptcy laws; and provided massive corporate tax breaks, loopholes, and other corporate subsidies all to the benefit of the wealthiest members of our society and to the detriment of just about everyone else.  (Krugman Saez Piketty Harvey Frank)  And what have been the consequences of all this? 


The consequences have been a dramatic deterioration in public schools, highways, bridges, parks, safety, health, welfare, and the environment; the creation of a corporate welfare state supported by the taxes of lower and middle-income people; the concentration of wealth, income, and economic power in the hands of fewer and fewer people; a ten trillion dollar National Debt that threatens the economic future of our children and grand children; and a financial crisis that threatens to create a worldwide economic catastrophe on an order of magnitude that could dwarf the disaster of the Great Depression.  If we are talking about class warfare here we are talking about a war that started sometime in the 1970s and in which all of the fighting has been by one side.  If the other side doesnít take a stand soon this war is likely to end in a Carthaginian peace from which we may never to recover.  (Frank Harvey Mayer N Klein Domhoff Krugman)



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