Future shock: The most dangerous idea of 2012

COMMENTARY The greatest threat to the U.S. economy isn't Greece defaulting on its debt, brinkmanship on Capitol Hill or Wall Street chicanery -- by now such developments are, in the lingo of investors, "priced in." Rather, the danger lies in an idea: That this country will recover without the federal government putting money in people's pockets.

This thinking is visible just about everywhere these days -- in congressional roadblocks to extending the payroll tax cut; in financial markets, where credit rating agencies squeeze Washington unless it in turn squeezes the poor and middle class; in Republican presidential candidates -- and President Obama -- singing the praises of deficit-reduction. Conceptually, it is as contagious as the debt plague afflicting Europe, with German Chancellor Angela Merkel a prime carrier. Behind every economic crisis lies a bad idea (usually distilled, as Keynes famously said, from some "defunct economist").

In short, austerity blows. Any hope of "green shoots" blossoming into a full-blown U.S. economic recovery is misplaced unless the feds start spending next year in order to create jobs and stimulate demand. Why? Because the housing bubble blew a $1.3 trillion hole in annual economic demand in this country and because Americans, who remain mired in debt, are in no position to fill that void all on their own. How do you replace that demand? Not easily. As economist Dean Baker notes, businesses only invest when they see an opportunity to make a profit, and profits won't pick up until demand does.

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Austerity "death spiral"

On top of this challenge, slashing government spending will make the crater even deeper. Henry Blodget explains:

The reason austerity doesn't work to quickly fix the problem is that, when the economy is already struggling, and you cut government spending, you also further damage the economy. And when you further damage the economy, you further reduce tax revenue, which has already been clobbered by the stumbling economy. And when you further reduce tax revenue, you increase the deficit and create the need for more austerity. And that even further clobbers the economy and tax revenue. And so on.

Basically, austerity puts you into a death spiral in which you keep trying to cut your way to prosperity, but all you end up doing is digging a bigger hole.

American history is clear on this point. In 1937, with the U.S. economy starting to emerge from the Great Depression, Franklin Roosevelt bowed to pressure from deficit hawks to cut spending and raise taxes. The result: The Dow Jones industrial average plunged nearly 50 percent. Manufacturing output declined more steeply than it had during the worst of the slump. Unemployment surged. Prices and wages fell, rekindling recession.

More than 70 years later, here we are again, as Republican lawmakers block efforts to cut taxes just as the economy shows signs of life. Whatever ideology or political motivations are behind this move, if payroll taxes are allowed to rise in 2012 the impact on people's paychecks will be clear. As a nation, we'll be poorer. The Center for American Progress, a Washington think-tank, illustrates state-by-state just how much taxes would rise for middle-class households next year:

How to grow

As painful as austerity has been in the short-term, it would hurt even more down the road. The U.S. economy is forecast to grow just north of 2 percent next year, before falling to 1.5-2 percent through 2016, according to a new report from the Levy Economics Institute for Bard College. Unemployment is expected to climb back above 9 percent. Such growth will do nothing to spark demand.

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And here's the thing -- that anemic growth is before $1.2 trillion in automatic federal budget cuts are supposed to kick in over the next 10 years, a result of last month's failure by the congressional "supercommittee." Factoring in those austerity measures, Levy predicts that U.S. GDP will shrink to a minuscule 0.06 percent in 2014 before leveling off at 1 percent. Unemployment would return to double-digits. The decade not only would be "lost," as in Japan's seemingly endless stagnation -- it would be doomed.

There is only one remedy: Spend. On the nation's decrepit roads, bridges and other transportation infrastructure. On health care, education, social services. On scientific research. The main argument against these measures -- that it would send inflation and interest rates soaring -- have been discredited. Let 2012 be the year such defunct ideas are put to rest.