The failure of economics in the runup to and aftermath of the Great Recession has generated a lively debate about how to reform economics and more specifically about the renewed relevance of Keynesian economics, which had fallen out of favor since the 1970s. The Keynesian message, so important in this latest round of political wrangling over the increase in the US debt ceiling, is that cutting government spending in a slump will only worsen the unemployment problem. The role of expansionary fiscal policy, according to Keynesianism 101, is to provide demand for goods (and thus for employees to produce those goods) when the main sources of demand in a capitalist economy — households and businesses – are not providing a level of demand necessary to generate a socially acceptable level of unemployment.

Keynesianism 102 is about the multiplier effect of changes in spending. This is the notion that an increase in demand (from any source, not just government but certainly including government) will impact employment and incomes with a ripple effect. This includes a direct impact and then a secondary impact when the direct incomes are then spent (in some fraction) and an additional fraction of that is spent, etc.

There are two corollaries to the lesson of Keynesianism 102 that are worth mentioning because they have been raised in the current policy debate. The first is about the differential multiplier effect of a spending increase compared to a tax cut. Empirical studies show that the multiplier effect of the former is greater than the multiplier effect of the latter. The second is about the differential multiplier effect depending on the income of the recipients. Since the poor are more likely to spend a higher percentage of additional disposable income than the rich, a tax cut that benefits low-income people will have a bigger multiplier effect than a tax cut that benefits the rich.

These lessons have not been integrated into current economic policy in the US, where deficit spending and progressive tax reform and expanded benefits for the poor and unemployed have been successfully resisted by the Republican congress. Nonetheless, they are well-established lessons of Keynesianism that most professional economists would accept.

The argument against Keynesianism 101 revolves around the psychology of investor confidence in the face of a rising fiscal deficit. The argument is that business people will reduce their investment spending when they see the government deficit becoming very large because it signals the likelihood of some detrimental future adjustment – either in interest rates, tax rates or government outlays – that will be detrimental for future profits. There is simply no empirical evidence to support this theory compared to Keynesianism 101.

But all this is sideshow in comparison to the lesson of Keynesianism 103.  The fundamental economic point of Keynes’s 1936 General Theory of Employment, Interest and Money was not about fiscal policy or the multiplier or income distribution.  It was about the fact that economic equilibrium (a stable condition from which no economic change would occur without external impetus of some sort) will not necessarily be characterized by full employment. Economists prior to (and some subsequent to) Keynes thought that free market economies would naturally adjust to full employment, as an excess supply of labor would lead to a lowering of wages and a corresponding increase in the amount of employment. Keynes explained that the natural state of a capitalist economy is “unemployment equilibrium,” and without a shock to aggregate demand conditions, there was no reason why the economy would not stay at this unemployment equilibrium. Keynes’s insight implied that the wage reduction strategy was not just theoretically wrong but, if implemented, would likely make the situation worse, since it involved a reduction in household buying power and thus would reduce business confidence.

A prospect as disastrous as the second “dip” that the American economy is about to experience is that of a long period of high unemployment that has no natural tendency to reverse itself. We should not stop our analysis at Keynesianism 101 and 102, since the great social problems facing America are understood best by Keynesianism 103.

So what is to be done? Paul Krugman has been a superb critic of the politicians’ focus on the deficit and the debt rather than on job creation. But he has been relatively quiet about what could be done if in fact the political winds were to shift. Robert Reich has been more explicit. His proposals for job creation include:

1. An additional cut in the payroll tax on employees and employers
2. An increase in infrastructure investment

My guess is that President Obama’s speech this evening will address these issues. If it does, it should be understood as not just a political maneuver, but as a serious attempt to tackle our economic problems.

From the fracas in Washington, it would be impossible to know that Americans still live in the world’s richest country. In 2010, the U.S. GDP was about two-and-a-half times that of its nearest competitor, China—you know, the country that’s building new cities everywhere and a bullet train system to ferry citizens among them. But to listen to the political discourse that currently dominates the airwaves, the U.S. is facing financial collapse, if not now then in another decade, and it cannot afford another dollar for many collective goods, whether an improved mass transportation system or health care for senior citizens.

As a number of commentators have observed, the political crisis over the debt ceiling is a distraction from graver and more urgent problems: especially the stagnation of the economy, which is not generating enough jobs to make much of a dent in the unemployment rate or to give young workers solid footing for the beginning of their career climbs. The Great Recession, supposedly over, is threatening to turn into a Japanese-style stagnation that could endure for a decade or more.

The state of the U.S. economy is bound up with the plight of the American middle class, as Robert Reich has acutely observed. That plight has been developing for decades, a lot longer than the debt problem, which dates back just a decade, to George W. Bush’s entry into the White House. The economic gains since the 1970s have been concentrated at the top of the income distribution, in the top few percent, and little has trickled down into the middle class. One widely cited statistic has it that the top 1 percent now take home about a quarter of the national income, up from just 9 percent in 1976;  the distribution of wealth is even more unequal. (By the standard statistical measure of income inequality, the Gini coefficient, the U.S. is now considerably more unequal than any other economically developed country and more resembles a developing nation like Nicaragua.)

The lack of economic gain by the middle class has fed directly into economic stagnation. In order to keep up their standard of consumption, many families have been going deeper and deeper into debt, encouraged in the last decade by the inflation of the values of their homes. The aggregate level of household debt in relation to GDP is higher than it has been since the Depression of the 1930s and is responsible for the weak demand that is keeping the U.S. from enjoying a robust economic recovery. Robert Reich’s basic message seems fundamental:  America has prospered when its middle class has done so; but their economic situation today is parlous.

The great damage of the current conflict over the debt ceiling is that it takes place, as Gary Fine rightly points out, on the terrain of conservatives. The Tea Partiers’ strategy of intransigence has worked. Accordingly, the discussion of remedies has been narrowed to the spending side: where are the cuts going to come from? Yet it isn’t that the federal government spends so much money, anyway. In 2010, the total level of spending of all levels of government in the U.S. amounted to 40% of GDP. That tied us with Canada but placed us well behind the levels of spending in Germany (44% of GDP), the United Kingdom (47%), and France (53%), all countries less wealthy (in terms of GDP per capita) than the U.S. As I noted in an earlier post, the increases in spending at the federal level under Obama so far are in line with those under Bush, with the exception of fiscal year 2009, a year of extraordinary economic turmoil that is divided between the two Presidents.

Not fully recognized is that a fall-off in government revenue plays an outsized role in the budget deficit. In nominal dollars, federal revenues today are about where they were in 2000, which means that in real dollar terms they are down by 16 percent. As a fraction of GDP, they have dipped to a level, less than 15%, that hasn’t been seen in six decades. The Bush tax cuts are an important part of the story, and most analyses point to them as the largest single factor behind the deficit. The recession and the halting recovery have also lowered federal revenues. Obama and the Democrats are right to insist that revenue increases must be a part of any solution, but in terms of the legislation under consideration to raise the debt ceiling this time around, they have lost the argument.

(And don’t listen to the right-wing whine that the affluent already pay more than their fair share in taxes. Conveniently for their argument, conservatives mention only federal income taxes, which amount to about 40 percent of federal revenue.  Almost as much is collected through payroll taxes, which, thanks to the cap on the income subject to Social-Security taxes, are mostly paid by ordinary workers.)

The resolution of the current tempest will last only for a while, six months if the Republicans are successful, eighteen if the Democrats are. The duel will be resumed, but we now see with clarity what the positions of the two sides will be. On the right, the prime target will be the entitlement programs, Social Security and Medicare, along with Medicaid, since the retirement of the baby boom over the next quarter century will ensure that the expenditures on these programs as they are currently configured will rise massively. On the center-left, the argument will be for more balance by raising revenues, but there has already been a concession that entitlement programs need to be cut back.

Any reduction in entitlement programs is equivalent to an additional tax on the middle class and the less affluent. For instance, Social Security is fully funded through 2037 because, since the Reagan administration, workers have paid extra amounts into the trust fund to build it up for the day when the baby boomers begin to retire. (The extra payroll taxes were recycled into the federal budgets of the time and spent.) To make the payments required in coming years, Social Security will need to go beyond incoming payroll taxes and tap into these savings, which effectively means that the money comes from elsewhere. Slowing down the rate of increase in Social Security payments to retirees, a proposal part of the Obama-Boehner negotiation, will slow down this transfer process and the need for more federal revenue. It will also give the retirees measurably less money over their lifetimes.

The debt ceiling crisis has pulled apart the curtains on a Washington political class that is at an impasse, unable to strike a “grand bargain” that would take the issue off the table. A “solution” therefore awaits the 2012 election, which may prove as momentous for the nation’s course as were the elections of 1980 and 2000. The Democrats under Obama’s leadership have given up considerable ground to the Republicans. But if the Grand Old Party takes the Presidency or the Senate while retaining the House, watch out!