So, Jamie Galbraith has lit into David Walker (h/t Krugman), the fellow who runs a foundation created with 1 billion dollars to fight the burgeoning deficit. Seems that David used the current financial crisis to launch into his favorite jeremiad against government deficits.

I’m not quite as sanguine as Jamie is about the long term financial shape of the US government, nor do I entirely agree with what appear to be his policy prescriptions (more on that in a bit), but I certainly do agree that Walker’s full of it. The US government has pledged about 5 trillion dollars in the last year to bail out the financial crisis. A lot of this money it will get back, but even so, 5 trillion is, well, real money, nor is there any particular reason to believe more money won’t be needed (in fact there is every reason to believe it will be.)

For all intents and purposes all of that money is going to rich people. It is all going to the financial sector to bail out people who paid themselves billions and billions of dollars of bonuses and salaries, who continue to do so, who have no shame, and who, while paying themselves that much money. destroyed the world financial system and are taking the world economy into a very very bad recession as a result.

And Walker wants the government, now that it has bailed out the rich, to stop there and not help the real economy significantly? Put aside the economics for a moment (which say that the government must spend or it risks an even worse economic recession) think about the fairness—the rich, having had their huge salaries are now being bailed out and are not being asked to pay for their own bailout with, say, a huge surtax on salaries over a million or a financial transactions tax, or even meaningful pay limits going forward.

But now, now that they’ve been bailed out with 5 trillion dollars, which they are still using to pay themselves bonuses for making no money at all for the past 4 years (yes, losses now exceed all the banks earnings in the past 4 years), ordinary people should not just pay the cost of the bailout but should get no money for the real economy either?

Let’s be clear, these 3 paragraphs from Galbraith worry me:

Not only that, sustained fiscal expansion (I dislike the term "stimulus" because I do not think that a short-term policy will work) will be essential in the next administration if the financial rescue just undertaken is to succeed. It will be necessary to stabilize the housing sector. It will be necessary to stabilize state and local government spending, undercut by falling property tax revenues. It will be necessary to stabilize the incomes and expenditures, in the aggregate, of the elderly. It will be necessary to finance new capital spending at the federal, state and local levels.

Failure to do this will cause the housing crisis to get worse. And that will cause the losses in the financial sector to multiply, overwhelming all efforts to stabilize finance.

I was at the Peterson Institute the other day. There I heard a very good panel discussion of the financial crisis, featuring Fred Bergsten, Adam Posen, Morris Goldstein and others. All agreed that the deficit would exceed one trillion dollars next year. All agreed on the need for the expansionary and stabilizing steps outlined above. Nobody was defending, in any serious way, the Walker-Steuerle line.

Galbraith is exactly right that if the economy keeps getting worse, the financial sector keeps getting worse, and the financial sector bailout fails. But the second paragraph worries me. It’s not that Galbraith’s wrong about most of this, he’s right. The Federal government is going to have to step in and stabilize spending. It’s going to have to more than stabilize spending.

But what it must not do is stabilize housing prices above the level they would have been without a property bubble. Because here’s the thing, all the money borrowed will have to be paid back (or more accurately, rolled over) at some point. While it won’t be the full 5 trillion, or 8 trillion, or whatever the final bill is, it’s still going to be a few trillion at the end of the day. And it’s not going to be financed forever at the concessionary 3 month rates the US is getting right now during the flight to safety. Long term rates are still high, and short term rates are, well, short term.

If that money is going to be paid back, there will need to be real economic growth in the US which translates into taxes. Ironically, since the US refuses to substantially increase taxes on the rich (yes, Obama has some minor tax increases on the rich, they are minor) that means it’s mostly going to be paid off by ordinary people and therefore their income and disposable income will need to increase. If housing prices don’t fall, and if mortgage payments don’t fall, either by the brute method of people walking away from their houses or from the better method of buying up mortgages at a discount and resetting them to term mortgages at more realistic face values, then Americans are not going to have significant disposable income for consumption or investment in the future (aka. savings). Take a look at the chart on the left, showing GDP before and after home equity withdrawals. Even after ‘stabilizing’ there isn’t going to be a new housing bubble. Where is discretionary spending going to come from? Where are savings going to come from? Is the rest of the world going to lend the US money forever at concessionary rates so the US can spend that money? Is there a real prospect of broadly rising wages for ordinary people which will make the burden of high mortgage payments lighter?

The US economy needs a restructuring. Propping the real-estate market up at an unrealistic level makes that restructuring much harder, in fact, probably impossible. A way to allow the market to decline needs to be found. Yes, Galbraith is right, collapsing housing prices make stabilizing the financial markets harder. But there are ways, such as a mortgage cram down, to do it. And more to the point, if you’re printing money anyway, you might as well print money to do it right. At the point where we’ve committed 5 trillion dollars, what’s another 2 or 3 to do it right, so the economy can grow again—so that people have money they can spend, so that housing is affordable to people who aren’t on the treadmill already?

As for Walker, he’s not wrong to be concerned about how the debt and deficit will be paid. He knows, as do I, that the US is completely dependent on the self-interest of other countries to be able to continue to finance itself. The second China or Japan or the Arabs decide to really cut the US off, is the day of reckoning. But since it’s too late to stop that dependence, since it already exists and just cannot be fixed right now short of crashing the US economy into a depression, or engaging in deliberate inflation which could lead to hyperinflation, well the goal is no longer to manage the headline numbers of debt and deficit, the goal is to restructure the economy so that it can start paying those numbers down and end the dependence. And that, perverse as it is, is going to require borrowing (or printing) even more money. Sometimes when you’re in a hole, it’s so deep that the only way to get out isn’t to stop digging, it’s to dig your way out. That, sadly, is where we are now.

So Walker is just wrong at this point. Wrong on the economics, where his plan will make things worse rather than better, and wrong on the morality, which says that bailing out Wall Street and refusing to help ordinary people is deeply immoral. Suggesting cuts in health care and social security after giving bankers trillions is so deeply wrong it borders on evil.