In the next six weeks there will be quite a few accusations and declarations about the 'parlous' state of the economy particularly from the left side of aisle. Blogger Dale Franks (whose politics I am NOT familiar with) sounds the alarm on the twin deficits (budget and current account) here. (click title) Unfortunately, his critique, while jocular and easy to read, is misapplied and off the mark.
Franks' contends that the US economy is on the 'left side' of the Laffer curve where tax cuts lose their effectiveness at stimulating the economy and hence lose money for the government. He punctuates his assertion with a clever story about how lower taxes lead to increased earnings which might induce us to seek more leisure and work less. There are two significant issues with his analysis. First, the stimulative effects of lower taxes require time to manifest. Like inflation expectations, the downstream effects of lower taxes on corporations and individuals alike do not occur overnight. If corporates and consumers believe that tax rates will stay low permanently rather than temporarily it will affect how they make investment and consumption decisions. Second, assuming that the American workforce does not immediately cut back on hours offsetting the effect of lower taxes more discretionary income is added to the pocket of the taxpayer which is either spent or saved. This is borne out by the average hourly work week which has remained steady.
Franks argues that once you are on the left side of the Laffer Curve tax cuts have to be paid for with reduced spending or tax hikes. However he offers no supporting evidence to his assertion of where we are on the Laffer Curve. In any case at this point in the recovery it would be singularly inappropriate to significantly cut spending or hike taxes. Franks offers yet another cautionary tale of citizens maxing out their credit cards and compares the US to an overleveraged consumer writ large. As compelling as that comparison tries to be there are some very important differences between how individuals and firms and a sovereign nation like the United States can and should manage their financial affairs. Whereas for individuals and firms the right answer during challenging times may well be austerity, the same is not true for the US government. First the US government has an unimpeachable sovereign rating, second, the government has the right to print money, and finally, the government has the ability and the obligation to be the ultimate economic countervailing force.
Franks then proceeds to warn that unreliable foreign capital is allowing us to live profligately. However, if at some stage the plug were to be pulled and foreigners repatriate their funds in short order we could be in real trouble--if, for example, the Vietnamese were suddenly unwilling to trade their dong for US. (cute) What Franks fails to recognize is the reality of the global financial marketplace. US government securities are considered riskless assets and these assets form a significant part of many investment portfolios. Countries like China aren't propping up the dollar to protect their economy, they are holding dollars because they want dollar investments for safety and duration. Also, the dollar is still the world's reserve currency, despite the euro, with key commodities still priced in the US unit. This phenonmenon also adds buoyancy to US assets.
It is certainly true that if the budget deficit were to continue to increase rapidly and require significant new borrowing that the allure of US government securities will suffer. However, since default is not a realistic outcome what the US then needs to draw investment are higher rates. As a percentage of GDP the budget deficit is within levels seen from the 1970s through the early 90s. At the moment foreign entities hold approximately 20% of all outstanding US securities--once again within the ranges of the past 25 years. The interest on the debt as a percentage of total expenditure stands at 14%, also well within recent ranges.
Fiscal and monetary policy is appropriately accommodative at this time at this point in the recovery with security expenditure (internal and external) historically high. We should continue to monitor our fiscal condition carefully but there is no reason to panic.
(Data above taken from publicly available US Treasury and Bureau of Labor Statisics sources)