Deficit reduction will keep unemployment high, new report warns
Wednesday, 16 December 2009

By Ronald Fink

Efforts to narrow the federal budget deficit will lead to a “growth recession” with no reduction in unemployment by 2015, new research warns.

An analysis published earlier this month by the Levy Economics Institute at Bard College in Annandale, NY, foresees unemployment remaining around 10 percent for the next five years if the deficit narrows as much as the Congressional Budget Office projects.

“Unemployment will remain stubbornly high unless there is a strong fiscal policy response,” wrote the authors, Dimitri Papadimitriou, president of the Levy Institute, and research scholars Greg Hannsgen and Gennaro Zezza.

The CBO projection, based on no further fiscal stimulus beyond the $787 billion provided by Congress earlier this year, forecasts the federal deficit falling from 11.2 percent of GDP this year to 3 percent in 2012 and remaining there from then on, thanks largely to increased income tax revenues as the economy recovers.

But according to the Levy Institute’s analysis, that scenario will do nothing to reduce unemployment, as the economy is unlikely to grow fast enough to reduce joblessness. Real GDP growth will resume but remain sluggish until 2015, staying “well below” the rate required to reduce unemployment, the authors wrote.

Without “strongly simulative fiscal policy,” they added, “unemployment will be the key economic problem for at least several years.”

The Levy report assumes the Federal Reserve will keep interest rates low and argues the policy is sustainable despite assertions by some critics. They noted the Fed’s liabilities are no larger as a percentage of GDP than they were in the wake of World War II, and indeed were mistakenly considered unsustainable when they reached such levels in the mid 1990s. The authors observed that the central bank’s liabilities have only recently returned to such a level as a result of its efforts to stem the financial crisis.

Yet the Fed can do little more to stimulate the economy and in fact seems more inclined to tighten monetary policy at this point out of fear of inflation, Papadimitriou wrote in an email to CFOZone.

“Most central bankers are concerned with finding the appropriate exit strategies despite the bad jobs picture,” he wrote. “What I am worried is that in late 2010, the Fed might follow suit with other central bankers who have begun to talk about or started raising interest rates.”

In the report, Papadimitriou and his fellow authors observed that Fed Chairman Ben Bernanke “has overemphasized government deficits.”

The researchers also take issue with those who contend government spending is ineffective as consumers defer purchases in anticipation of future tax increases to close the resulting budget deficit. “To show that this effect completely offsets the effects of higher government deficits requires assumptions that seem unrealistic,” the authors wrote.

As for the fear of others that budget deficits lead to higher interest rates as private investment is “crowded out,” they note that that the 3.5 percent increase in GDP during the third quarter without any rise in rates is evidence such fears during periods of “unemployed resources” are unfounded.

And while some analysts believe that a lower dollar, coupled with demand from developing countries such as China and India, can supplant weak U.S. consumption stemming from high joblessness, the Levy report contends such expectations are overly optimistic. The authors note that U.S. exports to China, for instance, represented less than 1 percent of GDP in 2008.

“Even a major increase in domestic demand in developing economies other than Mexico will have only a minor impact on U.S. exports, and hence on U.S. aggregate demand and employment,” the authors wrote.

While the researchers concede that depreciation in the dollar would put GDP growth on a more sustainable path by reducing the trade deficit, they contend the benefits will be limited, as oil producers have been raising prices to offset the decline in the dollar.

Indeed, the authors favor more spending on alternative energy projects as well as a continuation of the Bush tax cuts, because they contend this will both stimulate domestic demand and reduce the trade deficit.

“The government should devote more effort and money to developing alternative energy sources and encouraging energy conservation, as a devaluation alone would not have a large impact on oil imports,” they wrote.

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