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SOTU: The Dollar Gap Between Rhetoric and Reality

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In his State of the Union address Obama offered a corporate tax cut, a retooling of the tax code and an end to pet spending projects. All good. The tax code has long been used as a political plaything by Washington's mounting corps of lobbyists and special interests, so it will be interesting to see how much resistance the president will encounter if he is serious about ending this insidious form of corporate welfare.

Mr. Obama displayed his usual rhetorical flourishes, outlining what he called "a Sputnik moment" -- a blueprint for spending in critical areas like education, high-speed rail, clean-energy technology and high-speed Internet to help the United States weather the impact of globalization and the challenge from emerging powers like China and India. "We need to out-innovate, outeducate and outbuild the rest of the world," he said.

All true, but these types of things cost money, which at one level the president seems to recognize: "Countries in Europe and Russia invest more in their roads and railways than we do. China is building faster trains and newer airports." He noted at another point that the world's biggest private solar research facility and fastest supercomputer were now in China.

Which suggests that a token $50 billion allocation here and there won't do the trick: Consider the solar industry, which represents a perfect microcosm of the challenges the US now faces in regard to China. Beijing's command economy policy makers are piling subsidy on top of subsidy to make China's domestic market and domestic production the largest in the world. Its state-controlled banking system under government directive is financing capacity equal to a multiple of world demand on lending terms that make no sense for an industry with this much competition and flux.

The Chinese solar industry has been able to drive down solar product prices to levels that are too competitive for the most automated U.S. producers using the most advanced technology. As a result, the U.S. solar industry, including Evergreen, upon which President Obama has placed such high hopes, is departing the U.S. for facilities elsewhere, including facilities joint ventured with favored Chinese companies.

This encroachment by the Chinese into the global market for solar products is not occurring because China has especially low labor costs. It is not occurring because China has more advanced technology. It is occurring because China's command economy can force fixed investment in priority industries through a broad array of non-market means.

Owing to depletion of China's well of underutilized rural labor, wage costs in China are now soaring. Firms like Foxconn are looking to move their production platforms to lower wage economies. As a result, China is shifting its mega fixed investment more and more into higher tech industries, including capital goods industries.

Armed with massive arrays of subsidies and a willingness to build unprofitable companies in order to reach the technological frontier and global market dominance, China is now entering a new phase in which its mercantilism threatens the last bastion of U.S. manufacturing expertise.

Chinese objectives are as much geopolitical as they are economic.

For the U.S., today's casualty is Evergreen Solar; tomorrow's may well be Boeing. That's the scale of the challenge we now face. Yet the impressive SOTU rhetoric was undercut by the proposed 5 year freeze in non-security discretionary spending which the president said would save the economy, $400 billion from budget deficits over a decade.

It's useful to take any promise of government "saving" with a huge grain of salt. After all, most fiscal expenditures these days are largely non-discretionary and one can hardly predict with any degree of accuracy the "savings" that will accrue. This is because the ultimate government deficit after the spending freeze will reflect the interaction within the economy of the three major sectors: the domestic private sector (including households and businesses), the government sector, and the foreign sector. So unless some other sector is willing to reduce its net or increase its deficit spending (which means the private sector reducing its cash balances and taking on more private debt), then the mere attempt by the government to net save could well reduce overall levels of economic activity and offset the attempted savings brought about via the freeze proposed by Mr. Obama.

Fortunately, the president has decided not to embrace the British government's vicious assault on entitlements thus far. The SOTU gave no indication that the any future spending cuts would apply to the programs such as Social Security and Medicare. In fact, Mr. Obama appeared to reject further cuts, saying, "Let's make sure what we're cutting is really excess weight."

The best way to remove "government excess weight" is to have a growing economy. Full employment means we can enjoy the benefits of globalization; unemployment gives us another reason to fear overseas competition. "Bloated government" is not a significant problem when you have full employment. Just as surpluses precede recessions, large deficits can almost always be expected to result from recessions because of the automatic stabilizers that are in place. That is, budget deficits in the U.S. are largely automatic and non-discretionary: when the economy slides into a recession, tax revenues start falling as economic activity declines. Social transfer payments, particularly unemployment benefits, on the other hand, increase, again automatically, as more people lose their jobs. So recessions create budget deficits. Despite all the conservative uproar against Obama's stimulus plan, the largest portion of the increase in the deficit has come from automatic stabilizers and not from discretionary spending, which also means that his grand trumpeting of a freeze on the non-discretionary parts of the budget is more show than dough.

Finally, I want to say something about the president's aspiration to turn the U.S. into "an export superpower." It is becoming clear that not all countries can rely on exports to boost growth and employment; more than ever, they need to give greater attention to strengthening domestic demand. Competition in export markets often leads to domestic policy to keep wages and other costs low -- both to fight the domestic inflation pressures (fueled in part by the processes just outlined) but, more importantly, to compete with other low wage developing nations.

The typical outcome of these dynamics is that the domestic population does not share in the economic growth that is generated by exports. Poverty and social unrest often worsens even as the economy grows. Is this really what the President wants? How has being an "export superpower" worked out for Japan the last 20 years?

The ultimate paradox facing the president -- and the country as a whole -- is that while innovation, education and infrastructure are necessary ingredients for global competitive success, they offer no guarantee. But it is certainly the case that absent the fiscal resources deployed to confront the challenges outlined by the President (rather than continuing to shovel subsidies to zombie financial institutions), failure is certainly guaranteed.

Cross-posted from New Deal 2.0.