Austerity’s Legacy: GDP is Far Below Potential, and Not Climbing

Today’s GDP report was, not to get too technical, just crummy nearly across-the-board. Consumption spending was up, but the personal savings rate fell, meaning that the increased consumer spending was not financed by good wage and income growth, but by reducing savings. Exports fell sharply (hard to blame on bad U.S. weather) while most categories of investment fell as well. Core price deflators also ticked down again, signaling that economic slack is surely not shrinking.

One of the only bright spots in the report was that government spending is shifting from a large drag on growth to roughly neutral. This is what qualifies as decent news in today’s low expectations economy, I guess. We’ve tried to illustrate the historically large drag that austerity has put on the current recovery, in a bunch of ways. Here’s another try.

The figure below shows the simple percentage point contribution to GDP growth from government spending.  Two things stand out.

gdp blog1

The first is the quite muted rise in spending in response to the Great Recession. It’s essentially not that different from the rise in spending during the early/mid 2000s. We have all heard the attempts to label the Obama administration as big spenders (mostly because of the Recovery Act), but, it’s (unfortunately) just not true. Given the economic context, a much larger increase in government spending during the Great Recession and throughout the recovery would have been welcome.

The second thing to note is the incredibly sharp decline in spending that takes hold in (roughly) 2010 and continues nearly all the way through 2013. This figure shows 4-quarter rolling averages, so the number for the first quarter of 2014 is negative. Luckily, the stand-alone number for government spending in the first quarter of 2014 is essentially zero, so it should look a little better going forward from now. But, again, if one wanted to explain why the current recovery has been so anemic relative to previous recoveries, the data in this figure translate into the finding that that essentially the entire gap in GDP growth between the current recovery and historical averages can be explained by the contraction in government spending (for more on the arithmetic of this, see here).

Now, let’s move on for a second to the longer run. Below is a chart of the same indicator (percentage point contributions to GDP growth from government spending) over a longer run (from 1957). This time I added up all the government contributions (to avoid clutter) and did a 15-month rolling average. This is the length of the contraction in government spending during the current recovery, which started in the third quarter of 2010.

gdp blog2

I essentially wanted to see if there has been any other extended period of government contraction comparable to this last 15 months. I started in 1955 to avoid the WWII and Korean War drawdowns. There is one other nearly-comparable (though less extreme) episode where government spending has subtracted heavily from growth over a 15-month period—it’s highlighted on the graph. That 15-month period started in the last quarter of 1969 and lasted until the second quarter of 1973, meaning it was almost surely driven in part by a drawdown in Vietnam War spending (I checked, and, it is indeed significantly over-explained by federal defense spending). Further, it’s important to note the economic context when this contraction began: the overall unemployment rate in the last quarter of 1969 was 3.6 percent. The current period of austerity began in the third quarter of 2010, when the overall unemployment rate was 9.5 percent.

What to take from all of this? That the economy is starting 2014 so far below potential essentially entirely because of the historically unprecedented spending austerity, and that this austerity perversely began when the unemployment rate was extraordinarily high. We should not be surprised where we are today. Sadly, while the outlook for government spending (particularly fiscal) is better in 2014, the rest of the economy sputtered in the first quarter.

Quick caveats: these numbers do not include transfers (unemployment insurance and the like). Including transfers—like I did here—really doesn’t change the story that the current recovery has been historically austere. And, these numbers miss fiscal stimulus stemming from tax increases cuts [corrected from original]. In 2011 and 2012, the payroll tax was cut to provide fiscal support, so this does counteract some of the direct spending drag. Relative to earlier historical episodes, however, it’s not obvious that tax stimulus was all that much greater in the current recovery—the recoveries in the early 1980s and 2000s, for example, were characterized by larger (but more regressive, and hence less efficient) tax cuts as well.


  • beezer

    If the tax cuts didn’t spark any real economic improvement, then raising them probably won’t cause much harm. The reason: The cuts benefited people who weren’t going to spend much more money anyway, and the hikes will simply re-direct useless mounds of idle cash into something beneficial.