How Not to Mess Up the U.S. Economy: The Key Is Boosting Demand

Every 40 years or so, "American capitalism has to be saved from the capitalists," and the current economic slump appears to be one of those times.

Various conservative commentators today are spouting forth with flawed theories that, if implemented, would do little to strengthen a system that really benefits them. With that in mind, let's take a moment to get a few economic facts straight.

1. Supply-Side Economics Has Failed

The fundamental principle of supply-side economics -- that tax cuts for upper-income groups will lead to prosperity for all, jobs for everyone and rising median incomes -- has been proven false by history.

Not to say that supply-side economics, also known as "trickle-down economics," doesn't have some positive qualities. It does, but on the whole, it has been -- from its wealth-concentrating characteristics, to the way it leads to underinvestment in infrastructure, education, and basic research, to its grossly inadequate regulatory framework -- an economic failure.

For example, supply-side economics did create a massive amount of wealth. U.S. wealth is near its all-time high, and most of the Fortune 500's corporations are well-positioned for growth: productive, lean and flush with cash. However, one major problem, which DailyFinance'sPeter Cohan has chronicled, is that supply-side economics has allocated most of that wealth to upper-income groups, including the megarich. Of President George W. Bush's $1.3 trillion in tax cuts, 32.6% went to the top 1% -- a concentration of wealth that boggles the mind.

2. Austerity Measures Will Slow U.S. Economy

There's a belief among supply-siders, among others, that fiscal austerity measures will improve the economic situation: i.e. increase GDP growth and job creation. This, too, is misguided. Again, the problem is not the conditions that create the supply of capital or goods, but demand. Long-term, as economist Paul Krugman has underscored, government budgets have to be balanced and public debts paid for. But cutting spending and raising taxes now, while the system is already struggling with low demand for goods and services, will reduce demand even further -- exactly the opposite of what the economy needs. And it will reduce GDP.

Moreover, the austerity measures are not needed to lower inflation in the U.S. Inflation is already low -- indeed, the price trend is getting dangerously close to deflation. Nor are they needed to allow the government to lower interest rates. U.S. interest rates are near lows, and there's no sign of a rise on the horizon.

3. Fiscal Stimulus Works: See World War II and 2009

The argument that President Obama's $787 billion fiscal stimulus package didn't work because unemployment is still high is wrong. The fiscal stimulus package has reduced unemployment: Were it not for the jobs saved and created thanks to the stimulus measures, the U.S. unemployment rate might be at 15% today, or even higher, not 9.5%.

Indeed, the biggest problem with $787 billion stimulus package was that it wasn't big enough. As Krugman and others have noted, given the size of the hole the burst housing bubble and the financial crisis put in the national GDP, the U.S. economy needed a $1.1 trillion to $1.3 trillion stimulus package.

For a historic parallel, pro-stimulus economists point to the positive effects of government spending during the Great Depression. That era's version of stimulus is generally credited with reenergizing the U.S. economy -- though, as with the current situation, not fast enough.

The conservative argument asserts that World War II, not government fiscal stimulus, ended the Great Depression -- but it's a canard. Government spending rose massively -- peaking at about 53% of U.S. GDP -- during the armament and mobilization for World War II in 1941-1945. The federal government also controlled prices and rationed goods during the war -- but the economy still grew at a rapid rate. Massive GDP growth and job creation with government acting as the primary growth engine in the economy and amid government price controls and rationing: Now that's the free market working its growth magic.

4. The Real Problem Is Not Enough Consumers With Dough

There is no shortage of investment capital in the U.S. The country had $54.6 trillion in household net worth at the end of the first quarter 2010, up from $53.5 trillion in the first quarter 2009, according to U.S. Federal Reserve data. The problem, as Keynesian economists correctly argue, is not that there isn't enough capital (supply side), but that there aren't enough consumers (demand side), or at least Americans with incomes adequate enough to increase sales, and by extension, earnings, to make capital worth deploying.

Finally, the above is not to imply that those who have benefited the most from Bush's tax cuts -- upper-income groups and the mega-rich -- and who, in my interpretation, have not and do not pay their fair share in income taxes, will not have to make some sacrifices in the years and decades ahead. They will. But that price, say a maximum federal income tax rate of 45% or 50%, will be more than worth the goal of maintaining the U.S.'s current economic system -- corporate capitalism.

Upper-income groups and the megarich stand to benefit enormously if the U.S. economic system remains essentially the same. But the current system won't be sustainable if the unemployment rate continues to rise and pressure for bigger economic changes increases.

The Task: Increase Demand

Therefore, with the U.S. having registered a period of enormous wealth creation concentrated in the upper 1% of society, with inflation and interests rates both low, and with too few Americans earning enough disposable income to spend in ways that would promote GDP growth and new jobs the nation needs, the federal government's policy focus should be clear: Public policies should be implemented to increase demand.

Now, one can argue about what those demand-increasing policies should be -- tax credits, private-sector hiring incentives, stimulus spending for vital infrastructure improvements, direct hiring programs by the federal government or a combination of all of these -- but increase demand we must.

If we fail to do so, the economic results are inevitable: The U.S. unemployment rate will rise, making it almost impossible for the economic recovery to advance to a self-sustaining expansion. And the voices seeking bigger change and even more interventionist government policies will grow.

Joseph Lazzaro is writing a book on the presidency and the U.S. economy.