The best fiscal policy development of 2012 has been the near-universal refutation of the expansionary austerity hypothesis, and a better understanding of the risks of austerity-induced recessions. International evidence and economic research has lent credence to the welcomed realization that, in the United States, expansionary fiscal policy has been largely responsible for propping up anemic growth rates, and that recent pullback of fiscal support has already contributed to decelerating recovery.
In Washington, this realization has taken shape in the newfound bipartisan concern that the so-called fiscal cliff of legislated spending cuts and expiring tax cuts will push the economy into an austerity-induced recession if they take effect far into 2013. Policymakers have finally been forced to reckon with the macroeconomic reality that budget deficits closing too quickly—and public debt rising too slowly—will produce another recession. This necessarily implies that large U.S. budget deficits, swollen by economic downturn, automatic stabilizer spending, and deliberate fiscal support, have been keeping the economy out of recession, and that recent accumulation of public debt has staved off a much deeper depression.
(originally posted on Blog of the Century)
Policy makers are seeing that failed experiments with premature austerity budgets regrettably forced much of Western Europe—notably the United Kingdom and Eurozone—back into recession in 2012. The silver lining to this policy failure has been the complete debunking of the “expansionary austerity” hypothesis that cutting government spending cuts would somehow boost growth. To a much greater extent than in 2011, the case for austerity measures—when they cannot be cushioned by further monetary policy expansion—has been discredited, while Keynesian economics has been vindicated, producing a long-overdue and near-universal academic consensus about the benefit of activist fiscal policy in the context of liquidity traps.
Relative to recent years’ misguided but pervasive fear-mongering about rising U.S. public debt and hyper-partisan bickering over the efficacy of expansionary fiscal stabilization policy, these developments would—in a sane world—help reorient fiscal policy back to supporting recovery.
In 2010 and 2011, U.S. policymakers pivoted away from prioritizing economic recovery and toward premature austerity measures and deficit reduction, epitomized by the thoroughly misguided Budget Control Act of 2011. Federal fiscal policy has increasingly dragged on growth since mid-2010, driven by the withdrawal of deliberate fiscal stimulus—particularly the American Reinvestment and Recovery Act—coupled with escalating discretionary spending cuts; this pullback in fiscal support has coincided with shrinking deficits and decelerating trend economic growth. Conservatives and some centrists advocated for this pivot as a rejection of Keynesian “sugar high” fiscal support and the (now demonstrably wrong) belief that cutting the budget deficit would, through confidence effects and reduced interest rates, actually boost economic activity. For instance, in 2011, the Heritage Foundation released dynamic economic projections to accompany House Budget Committee Chairman Paul Ryan’s (R-Wisc.) fiscal 2012 budget resolution that absurdly showed government spending reductions boosting GDP growth (i.e., assigning a negative fiscal multiplier—the “bang-per-buck” of tax and budget policies).
But today, there is no serious disagreement about the positive sign (and more subdued disagreement about the magnitude) of the government spending multiplier. Any policymaker espousing concern about “going over the cliff” is necessarily adopting the fundamentally Keynesian policy argument that government spending cuts (and, to a lesser degree, tax increases) are contractionary. And, as Paul Krugman pointed out, recent years’ opponents of fiscal stimulus—those arguing that government spending necessarily crowds out an equal amount of private spending through Ricardian equivalence—would today have to reject the mere possibility of a “cliff” or austerity-recession, now a rare and ostensibly indefensible stance.
Perhaps the most conclusive demonstration of revised economic thinking on activist fiscal policy versus austerity measures this year came from the International Monetary Fund’s October 2012 World Economic Outlook, which concluded that “[government spending] multipliers used in generating growth forecasts have been systematically too low since the start of the Great Recession by 0.4 to 1.2, depending on the forecast source and the specifics of the estimation approach. Informal evidence suggests that the multipliers implicitly used to generate these forecasts are about 0.5. So actual multipliers may be higher, in the range of 0.9 to 1.7.” In other words, the damage inflicted by austerity cuts across developed economies has been roughly 80 percent to 240 percent worse than widely estimated when austerity was being advocated in 2010.
For U.S. policymakers, the most valuable international lesson of 2012 comes from the United Kingdom, which suffered housing and financial asset bubble collapses relatively similar to ours, has experienced comparable loosening of monetary policy (both conventional policy interest rate cuts and less conventional asset purchases, or “quantitative easing”), and does not face the sovereign default or currency risk premiums beleaguering the peripheral Eurozone nations. In 2010, a newly elected coalition government headed by Prime Minister David Cameron enacted an austerity budget, which at the time was lauded as the responsible course by technocrats and centrist consensus types such as the IMF and the editorial staff of the Economist. But the perverse economic effects of this “Cameron budget” were not fully visible until 2012. Today, we know this austerity budget pushed the U.K. back into a three-quarter recession starting in the fourth quarter of 2011 and, after a brief respite in the third quarter of 2012, central banker Mervyn King has warned of a return to economic contraction, possible resulting in a triple-dip recession.
There should be a steep and timely learning curve on this side of the Atlantic from these experiments and research on austerity in the context of depressed economies and already-loose monetary policy. And, on face value, “cliff” concerns about an austerity recession express just that. But while this represents a huge step toward more productive budget policy, many U.S. austerity advocates have been unwilling to concede that what they were proposing in 2010 and 2011 was and remains premature; instead, they have tried to invert fears of the “cliff” sparking a recession in order to promote a bipartisan deficit reduction “grand bargain.” This is nonsensical political opportunism demonstrating zero learning curve—the worst of fiscal policy in 2012.
Intrinsically, a grand bargain that accelerates or maintains the pace of deficit reduction relative to current policy is antithetical to the challenge facing policymakers, which is moderating the pace of deficit reduction in order to sustain overall economic growth. In public discourse, this remains totally lost on much of Washington’s policymaking elite. For instance, former Senators Pete Domenici (R-N.M.) and Sam Nunn (D-Ga.) recently argued in the Washington Post that enacting a bipartisan “grand bargain” would be instrumental in addressing the fiscal cliff without identifying the one and only way a grand bargain could ameliorate the threat posed by the “cliff” and instead opposing “kicking the can down the road,” i.e., slowing the pace of deficit reduction. Worse, there is a more destructive inverted discourse in which “cliff” is implied to be synonymous with a crisis of too much debt (e.g., sovereign debt crisis) instead of a crisis of overly rapid deficit reduction.
The grand bargain most frequently invoked as a talisman for fiscal seriousness and a template for deficit reduction is the Moment of Truth report by National Commission on Fiscal Responsibility and Reform co-chairs Alan Simpson and Erskine Bowles. But the Bowles-Simpson report was the U.S. equivalent of the Cameron austerity budget, with the nontrivial exception that the United States neither fully enacted an austerity budget nor followed the United Kingdom back into recession. And the co-chairs report is less credible today than it was two years ago. When the Bowles-Simpson report was released in November 2010, U.S. economic output was operating 6.0 percent depressed below potential GDP, versus a comparable 5.7 percent depression as of the third quarter of 2012. So the economy is roughly as vulnerable to austerity cuts, and a plethora of international experience and academic research has discredited the premature austerity they were advocating in 2010.
And the counterfactual is pretty damning. Not only did the Bowles-Simpson plan propose premature spending cuts starting in October 2011, but it also would not have accommodated the deficit-financed payroll tax cuts and emergency unemployment benefits that Congress enacted for 2011 and 2012. This fiscal retrenchment would have reduced real GDP growth by 1.3 percentage points in fiscal 2012 and another 2 percentage points in fiscal 2013, lowering nonfarm payroll employment by 1.6 million jobs in fiscal 2012 and 2.4 million jobs in fiscal 2013, relative to the path Congress took and current budget policies. Trend real GDP growth would be just slightly positive (meaning labor market conditions would be deteriorating rather than treading water), and the United States would almost certainly be zigzagging between expansionary quarters (e.g., fourth quarter of 2011) and contractionary quarters (e.g., first quarter of 2011 and second quarter of 2012).
The only point of long-term deficit reduction is improving future living standards, but while the economy remains nearly $1 trillion depressed below potential, big budget deficits don’t threaten future living standards. Conversely, premature austerity that delays or precludes full recovery threatens future living standards, notably through economic scarring, forgone national income, and decreased public investment.
But the policymaking elites refuse to acknowledge this and continue to fantasize that confidence and interest rate effects from deficit reduction will inexplicably spur recovery, or that failure to reduce budget deficits will spawn an even worse outcome of soaring inflation and interest rates. Until the economy fully recovers, there are negligible risks of big budget deficits accelerating the rate of inflation or crowding out private investment by forcing up interest rates. And full recovery is not expected until between 2018 (under CBO’s optimistic projections that continuously are revised backwards) and 2020 (extrapolating from trend labor market performance in 2012). Conversely, when interest rates and inflation start rising, it will mean the economy is approaching full recovery—good both for living standards and fiscal sustainability.
This “half-triumph” of Keynesianism is a welcomed development, and we can only hope that it has not come too late to avoid a slide back into recession. On the flipside, the failure of far too much of the centrist policymaking elite to acknowledge these painfully learned economic lessons and adopt evidence-based policy responses is assuredly the greatest disappointment—and indicative of the depressing state of U.S. economic policymaking.