A present under every tree!

Tuesday was a very busy day for observers of US economic policy. President-elect Obama met with US governors to discuss the impact of the recession on state-level finances, and Detroit’s Big Three automakers revisited Washington to unveil their new plans for turning around the moribund US car industry and to seek handouts from Uncle Sam.

Already, ideological battle lines are being drawn.

Most Democrats in Congress, as well as many in statehouses around the country, are in favor of what they term “jolting the economy” back to life. This would be accomplished via massive deficit spending on a variety of fronts, including bailouts for Detroit, infrastructure and clean-energy make-work programs around the US, and continued aid to both banks and consumers. This view would appear to occupy the heights in the ongoing discussion.

There are, however, a small group of dissenters, mostly Republican, who view this level of intervention as unnecessary and potentially damaging to our long-term economic health. Running point for this group is Governor Mark Sanford of South Carolina, a noted fiscal conservative with an impeccable record of fiscal and budgetary rectitude. Last night alone, he appeared on The News Hour with Jim Lehrer and on Bloomberg TV, where he essentially repeated talking points from earlier in the evening.

The most salient point Governor Sanford has to make, at least in my estimation, regards the long-term impact of high deficit spending on inflation. There seems to be great disagreement in the public policy community regarding the potential danger of runaway inflation resulting from the massive bailouts and stimulus packages working their way through the halls of government. Some feel the danger is more than offset by the specter of high unemployment and the very real contraction taking place in the greater economy. Others believe that inflation – at least, of a moderate sort – can actually help our present situation by reducing the real level of debt that companies and consumers need to service. Still others, like Congressman Charles Rangel (D-NY), don’t really care at all how fouled up the federal balance sheet gets and have said so publicly. And then, still others feel that the bigger worry over the next few years is deflation, not inflation, which is a topic for another day.

To my mind, Governor Sanford is correct, broadly speaking. While his arguments in favor of “market-oriented” solutions sound silly given that financial-industry deregulation is to blame for many of the current problems, he is right to question the premise of further bailouts, not because an expansion of government is bad per se, but because the federal balance sheet is already so weak that new deficit spending would have severe, if not catastrophic, consequences. Many folks on the other side of the aisle simply don’t want to entertain the notion that massive deficit spending has real-world effects. Their assumptions are too rosy and too narrow regarding how much good can be derived from the stimulus that deficit spending entails.

Instead, proponents of further stimulus talk of job creation as Priority #1. They need to be disabused of this idea. The unemployment situation has not yet reached crisis levels nationally. We should monitor unemployment very closely in the short-term, but the simple fact is that an unemployment rate of less than 7% during a financial and economic crisis of this magnitude is, all things considered, not bad at all. It certainly does not merit massive federal budget deficits to “put people back to work,” as Jennifer Granholm, the governor of Michigan, stated last evening.

Having said that, the current recession is hitting some areas much harder than others, Governor Granholm’s home state of Michigan being a prime example. At this point, I’m not sure what can be done in the short term to improve economic performance in these depressed areas. Much of the problem in these areas pre-dates the current crisis and has roots that go back many years, if not decades. For example, it is unfair and misleading to suggest that the current crisis brought the US auto industry to its knees. To any reasonable observer, this day of reckoning has been coming for a long, long time and is the result of exceedingly poor management, as well as the excessive influence of labor unions on business strategy.

That doesn’t change the fact that much economic pain would be unleashed by bankruptcies in the auto industry, but the point is that there is absolutely no guarantee that the US auto industry can be saved. Its business model is broken – that’s why its CEOs are in DC lobbying for a bailout. Without wholesale change in Detroit – from top to bottom – a federal bailout is merely throwing good money after bad.

And there is a credible argument that much the same could be said for the American economy at large, not because it’s “model” is broken, but because the risk-reward ratio tilts away from creating unsustainable jobs in the short-term by taking long-term liabilities onto the Fed’s balance sheet. After all, once the “stimulus” runs out, what then? All those make-work jobs evaporate, and you’re left with essentially the same set of problems.

Ordinarily, I would agree with Governor Sanford that the private sector needs to be a big part of the solution here, but right now, the private sector is in a spot of bother. The bottom line is that what we are seeing – and need to see more of – is a massive de-leveraging in which unsustainable levels of debt must be retired or otherwise disposed of. This will consume capital that would otherwise be invested in growth. This process will take years. Only then will the private sector return to health, and no amount of “stimulus” is going to change that. I’m not against a targeted and relatively modest shot of economic aid to help those people most at-risk around the country, but I cannot support the kind of no-holds-barred packages being contemplated in Congress. We should err on the side on fiscal caution, realizing that any stimulus is of limited utility and indeed could be more harmful over the long term.