The budget deficit poses a dilemma for the incoming Clinton administration. It is impossible to simultaneously cut the deficit and provide an economic stimulus through increased government expenditures.
Moreover, it is difficult to cut the deficit while the economy is performing poorly. Tax revenues (absent a rate hike) increase, and expenditures for unemployment and welfare benefits decrease, when incomes are increasing, not when they are stagnant or declining.So what should the new administration do? It should apply a fiscal stimulus - but carefully. The trick is to use government spending to help growing sectors of the economy, and to structure the stimulus so it can be reversed quickly if it becomes inflationary.
Slow growth was a major issue in the presidential election, not because the economy had not begun a recovery but because the turnaround has been too slow.
Recession almost always means a shortage of total demand - that is, less demand than what is required to purchase the output of an economy at full employment.
Normally, a shortage of demand is self-correcting: Industries facing declining markets reduce output, but their laid-off workers find jobs elsewhere, in expanding sectors of the economy.
In a recession, though, that adjustment process breaks down. The transfer of resources doesn't happen fast enough: Workers and factories spend a long time unemployed.
That, in turn, reduces demand for the output of other industries. Those companies, facing declining demand, have trouble servicing the debt they acquired to finance productive activity. Consumers, worried about their jobs and the financial safety of their savings, cut back, even though they may have the money to continue consuming as much as before.
During such a contraction, an increase in government spending should enlarge total demand, thereby reversing the contraction. Since the government now is spending more than it collects in taxes - hence the budget deficit - one would expect total demand to be expanding; in that case, no additional stimulus should be needed.
But the expansion is not happening. Somewhere, despite the deficit spending, there is a subtraction from total demand. Where is the leak?
One leak is the trade deficit. The United States is a net borrower of foreign capital and those foreign funds must be changed into dollars. The only way foreign economies can obtain more dollars (for investment in the United States) is to sell more to the United States and buy fewer U.S. goods. That, in turn, raises the U.S. trade deficit.
So, to the extent that a fiscal stimulus results in more foreign borrowing, it raises the trade deficit - thereby taking away with one hand what it gives with the other.
The trade deficit is not the only leak in the economy. A second leak must be the use of current income to retire debt. This "unborrowing" is the same as an increase in saving, but it is not counterbalanced by increased investment.
A third leak is the collapse in the value of property in sectors that have become overbuilt. The list of such industries is long: housing, commercial real estate, retailing, defense industries, cars and computers, among others.
The loss of income from jobs and from stocks and bonds invested in those industries becomes generalized. That affects the demand for output from unaffected sectors.
Since the affected sectors will have to contract, using a stimulus to preserve jobs in them is a waste. For example, buying unneeded weapons such as the Osprey helicopter-airplane amounts to throwing money away.
It is equally wasteful to try to preserve jobs in industries with excess capacity. For example, it became clear 10 years ago that Japanese car companies were building factories in the United States and were likely to increase their market shares here. It was inevitable that U.S. manufacturers would shrink.
Instead of using its political and financial resources to prop up declining industries, the government should use a fiscal stimulus to speed up the readjustment process. It should pay for training, adjustment assistance, investment and removal of barriers to growth in the sectors that are expanding.
Where, specifically, should such investments be made? The traditional answer has been to invest in infrastructure, such as roads and airports, and in rapidly expanding sectors such as health care.
Another productive approach to economic stimulus is to focus on industries that have promising technologies but that require legal or regulatory changes to fully exploit those technologies. The telephone companies, for example, are ready to build a fiber optic network but must be allowed to supply data and home entertainment to make that investment profitable.
Above all, a fiscal stimulus should be applied carefully: Government must be able to turn it off before it becomes inflationary.
If the government does not do so, and continues spending freely even after an upturn, it could run up the federal debt once again. That, in turn, could reduce a government's political option to respond in the future to the rainy day of recession.