"1. I don't think a sudden and drastic reduction in federal spending would necessarily cause bank failures."
I can say with scientific certainty that if the government is forced to go cold turkey into balanced budget mode it will immediately mean that there will be about 40% less currency reserves circulating in the commercial banking system. Draw whatever conclusions you want about what the consequences will be, but the old analogy of musical chairs seems appropriate because when the music stops there will be about 40% fewer chairs out their for people to sit down on. In my opinion, forced sudden austerity of this kind will likely produce similar results to Spain and Greece where unemployment has risen above 26%. Note also that the budget deficits in those two countries continue to grow larger as their depressions deepen.
"2. I agree that budget cuts would cause a recession, and this would cause tax revenues to fall, requiring further budget cuts. However, firstly, this is a good thing!"
Hmmmnnn..... So, just to clarify my thinking, you think that another recession and the higher unemployment that would go along with it would be preferable to the current economic situation?
"Even if federal spending were reduced to the level of present tax revenues, that's still far too much spending."
I don't disagree with you on that count. I would just prefer to downsize the public sector government share of the economy by having the private sector grow faster until such time as government spending as percent of GDP is more like 10% to 15% rather than the current 25%.
"Secondly, it is not true that this would prompt an endless downward spiral: that's Keynesian nonsense. The recession would allow for the reallocation of resources (currently misallocated thanks to government interventions) to more highly valued uses. For example, resources might flow away from housing (currently subsidizes by the federal government) and into a more productive field. This is the cure, not the disease, though it might be unpleasant in the short term."
You may be right. Can you cite an example?
"So, in other words, you favor no spending cuts at all? You think we can grow our way out of this problem?"
Yes I do think we can grow our way out of this economic problem. The economic recovery, weak and tepid as it is, is nevertheless producing enough additional tax revenue relative to current government spending to reduce the deficit by $206 billion in 2012. Look at the deficits of the Bush years which weighed in at about 4.7% of GDP in 2004 after the second round of tax cuts and subsequently declined to about 1.2% of GDP by 2007 before exploding again with the 2008 recession. The last thing any of us should want to do right now is to trigger another economic relapse into recession.
That said, the whole debt ceiling impasse is a straw man because there is a better way to deal with the immediate crisis and that is to try what Ron Paul suggested back in the summer of 2011 during the first round of debt ceiling battles.
The $16.4 trillion national debt is partly an illusion, because the Federal Reserve owns $1.65 trillion of it, which it purchased through its QUANTITATIVE EASING (QE) operations.
In recent years the Fed has been earning about $80 billion a year in interest income from these Treasury holdings and it earned $90 billion in 2012, $87 billion of which was simply remitted back to the Treasury.
In other words, this is debt that the Government owes itself! Our children and grandchildren aren’t even involved and they will not be saddled with this debt as long as the Fed holds on to it. This raises the question about why this $1.65 Trillion of Treasury debt held by the Fed should even apply to debt ceiling.
After all, what difference is there between the Treasury issuing debt only to have the Fed buy it back, vs. the Treasury not issuing that debt in the first place?
Is there any good reason why the Treasury and Federal Reserve couldn’t simply wave a magic wand over this $1.65 Trillion of debt held by the Fed and in effect cancel it? This would reduce the outstanding debt to about $14.75 Trillion which is well below the current statutory debt ceiling of $16.394 Trillion.
Ron Paul promoted this course of action as a means to bring lasting savings to the federal budget and interestingly enough he was endorsed by Keynesian economist Dean Baker writing in the New Republic in July, 2011. "Ron Paul’s Surprisingly Lucid Solution to the Debt Ceiling Impasse"
There are also these articles which appeared more recently ( mid-Oct ) in the FT blog and Seeking Alpha....
The debt cancellation idea is only a temporary solution to the debt ceiling time bomb, but it would buy Congress about a year or so of valuable breathing space to formulate sensible pro-growrth economic policy rather than causing a self inflicted wound on the economy and millions of American workers and businesses.
Mr. Bernanke, if you seek transparency and accountability for the Fed…. If you seek prosperity for the American people then come to Congress and tell our law makers that the Treasury debt held by the Fed should not apply to the debt ceiling. Mr. Bernanke TEAR UP THIS DEBT!
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