Fiscal Austerity and “Third World America”

kristy Reforming Global Finance

By Simon Johnson

My testimony to the Senate Budget Committee on these issues is available here:

There are three main views of the financial crisis and recession of 2008-9. In the first two views, the debate over the fiscal deficit is quite separate from what happened in the crisis. But in the third view, the financial crisis and likelihood of fiscal austerity are closely linked.

The first is that something went wrong with the financial plumbing central to the world’s economy. Failed plumbing is a serious business, of course – great real estate can be ruined by a burst pipe. But it’s a technical issue; nothing deeper is at stake.

The Dodd-Frank financial reform legislation ended up addressing a myriad of technical issues. Clearly, “fix the plumbing” is Treasury Secretary Timothy Geithner’s interpretation of what we need to do – he insists that making the system safer just requires “capital, capital, capital.”

The second view is that the financial system is more deeply broken. Opinions vary in terms of the relative importance of various elements, including too-big-to-fail incentive problems that encourage banks to take on excessive risks – and to be supported by the credit markets when they do.

The first and second views are mutually exclusive – either our financial system is badly broken, or it is not and technical fixes will suffice. Both focus primarily on the nature of the financial system, somewhat in isolation from the rest of the economy. But a third view is increasingly emerging that implies both the first two views are too narrow.

This deeper critique is posed probably in its sharpest form by Arianna Huffington in her new book, “Third World America” (in the spirit of disclosure, please note that I am a contributing business editor at the Huffington Post). Her point is that we should not think of the last financial crisis in isolation, but rather as the outcome of a longer-run pattern of behavior. Excessive consumer debt is an outcome of prolonged inequality – in trying to remain middle class, too many people borrowed too much, while unscrupulous lenders were only too willing to take advantage of such people.

Raghu Rajan, the former chief economist at the International Monetary Fund, and Robert Reich, the former Labor Secretary, also have new books with related themes that link persistent inequality of income to the onset of financial crisis through various mechanisms – Mr. Rajan’s “Fault Lines” is more about the global economy (and overspending at the level of the US economy); Mr. Reich’s “Aftershock” focuses on the social and political impact of the crisis (and why, without addressing inequality, our financial problems will recur).

The distribution of income in the United States is undoubtedly becoming more unequal. Specifically, over recent decades, it has become harder for people with only a high-school education to build a secure middle-class future for their families.

We can argue about proximate causes, including the relative roles of new technology and globalization, but there is no question that unionized jobs, well-paying assembly line work and prosperous small-business niches have all tended to disappear.

The financial crisis may be behind us, but the link to the likely intense debate this fall regarding fiscal policy is direct — we are told that fiscal austerity requires outright and immediate further cuts in the benefits previously promised to people at the federal, state and local level.

Never mind that this is simply not true – at least in the form currently presented (here are a primer on short-term issues and another on the longer-term perspective). A vocal class of people – including some at the upper end of the income distribution – incessantly insist that “entitlements must be cut” while refusing to address the real causes of both our recent surge in government debt (the financial crisis, caused by perverse incentives in the financial system) and the genuine longer-term issues we face (which are about controlling the future increase in health-care costs – not cutting the level of benefits today).

The self-described “fiscal conservatives” really cannot be taken seriously – in the financial reform debate, they either didn’t show up or preferred to keep the existing system in place, and they refuse to put serious health cost-control measures on the table.

If the “conservatives” don’t really want to reduce the shocks that have caused government debt to explode recently – or to deal with the underlying, longstanding health-care cost issues in a reasonable fashion – what exactly is going on?

That’s a question they should answer for themselves, and hopefully they will be pressed on this in public debates during the run-up to November’s elections. But there is a striking similarity between the longstanding stated intention to “starve the beast” (meaning press for reduction in government by creating binding constraints, like a perceived crisis) and what we are seeing play out today.

And there is very real danger that this strategy will work, in the sense that the contours of a coming “fiscal crisis” – what will be discussed and how the issues are framed – will largely be structured by scaremongers who wish to cut pensions and health-care benefits for middle Americans in the years ahead and who will work hard to keep meaningful tax reform off the table.

People who push for this view are not being fiscally responsible, and they are well down the road to exacerbating third world-type problems in the United States – and to creating the conditions for another financial crisis.

As drafted for the NYT’s Economix blog; used here with permission. If you would like to reproduce the entire post, please contact the New York Times.