True deficit hawks would be worried with jobs and recovery first

In a recent blog post, we made the point that the debate over the “fiscal cliff/obstacle course/austerity crisis” is fixated on the too-modest goal of avoiding outright recession in the coming year, rather than actually pushing the U.S. economy back to full economic recovery. This latter goal—actually ending the economic slump that began with the Great Recession in late 2007—is obviously politically unrealistic (which, by the way, should be sign one of just how deranged D.C. policymaking has become), but we should be clear that it’s the right thing to do.

FULL ANALYSIS FROM EPI: Budget battles in the lame duck and beyond

The U.S. economy has already forfeited literally trillions of dollars in national income by not pushing the economy back to full health after the Great Recession. Knock-on effects of this policy failure include damage to future potential income from economic “scarring;” to put it simply, allowing productive economic resources (both people and capital) to sit idle and atrophy is exceptionally inefficient. A less important knock-on effect of this continuing slump is that it will predictably cause future projected budget deficits to balloon. Yet far too many self-proclaimed deficit hawks among D.C. policymakers seem strangely unconcerned about this particular driver (continued economic weakness and unemployment) of future budget deficits, and too many are instead advocating near-term fiscal contraction that will further delay recovery.

The U.S. economy is running $973 billion (5.8 percent) below potential economic output—what the economy could produce with higher (but noninflationary) levels of employment and industrial capacity utilization. Cumulatively, these output gaps imply that the U.S. has forgone roughly $3.6 trillion of national income over 2008—2011, projected to hit $4.6 trillion by the end of 2012.

Moreover, the Congressional Budget Office’s (CBO) economic baseline shows output gaps persisting into 2018: Under current law, another $3.5 trillion worth of cumulative output gaps are projected over 2013–2017. These forecasts are likely overstated in the near term, as Congress probably won’t actually allow all the fiscal contraction baked into current law to actually come to pass. Still, CBO’s current economic forecast indicates a decade-long economic slump, in which the United States will forgo $8.1 trillion of national income, and even any short-term overstatement of this gap leaves this a staggeringly large number.

Moreover, even this bleak outlook presumes that the U.S. economy will naturally (and rather quickly, once the process begins) revert to growth rates sufficient to reach its full economic potential over the next five years or so. CBO’s most recent forecast shows recovery rapidly accelerating starting in late 2013, with real GDP growth averaging 4.5 percent over 2014—2016 (more than twice trend growth since recovery began); this spurt of growth exceeding potential GDP growth would close the output gap.

Should we bank on this recovery? Probably not, even though it seems that most of the deficit reducing industrial complex in D.C. is banking on it.

As an empirical matter, the CBO projections have consistently issued premature dates for when full recovery will occur; the 2014 recovery expected back in CBO’s Jan. 2010 forecast is now projected for 2018. And so on.


At a more theoretical level, the CBO projections (and they are not unique or particularly bad in this way, it’s a standard modeling assumption) basically always assume that the economy has natural mechanisms that push it back toward potential after negative shocks. And such mechanisms do exist—though the really powerful mechanisms, it should be kept in mind, are institutional, not simply “market-forces.” For example, when the economy is hit by a negative shock, the Federal Reserve loosens monetary policy. And when the economy is hit by a negative shock, falling tax collections and rising safety net spending automatically—bigger budget deficits—provide a shock absorber to growth.

But when shocks are large enough, they can actually create feedback loops that amplify the economic slump. For example, lots of excess slack in labor and product markets puts fierce downward pressure on price growth. And when wages and prices are rising at, say, 2 percent per year rather than 4 percent, it takes longer to emerge from the overhang of household debt. Relatedly, this shock was so severe that even historically aggressive loosening of monetary policy was insufficient to spur full recovery; the Fed has long exhausted its conventional policy levers (short-term interest rates have been ostensibly stuck at zero since Dec. 2008, and are promised to remain there through mid–2015) and is no position to cushion sharp fiscal contraction, let alone spur 4-plus percent growth rates with unconventional measures (e.g., buying more mortgage-backed securities or Treasuries to lower longer-term interest rates).

It is time to stop taking this mechanical return to full employment for granted, and use the tools of policy to force its return, as there are a number of historical examples of economies that essentially forfeited decades at a time because policymakers didn’t make return to full employment a pressing enough priority. Our own economy during the Great Depression saw growth when policymakers provided support through monetary and fiscal means (mostly between 1933 and 1937), but faltered when this support was drawn back, and saw full recovery only when external events (the defense boom spurred by World War II) demanded a huge macroeconomic expansion. And Japan in the 1990s and early 2000s followed a similar pattern of sawtooth growth, which accelerated when policy supported it but flagged when policy support was withdrawn too soon. Today, the United Kingdom, which recently re-emerged from a three-quarter austerity-induced recession, may be stuck in the same pattern, as central banker Mervyn King recently warned of the U.K. zigzagging into a third recession.

So what if economic recovery in coming years follows these examples, and will only respond quickly to expansionary policy? And what if this policy becomes contractionary as is currently forecast? One way to extrapolate trend economic performance is to hold the output gap constant as a share of potential GDP from 5.8 percent in the third quarter of 2012, essentially a continuation of current budget policy with no exogenous boost to growth (e.g., improvement in the trade deficit, spike in residential investment, etc.). Alternatively, one sees what happens if GDP continues to grow at the 2.1 percent annualized rate that has characterized the recovery to date.

Both projections show somewhat smaller output gaps in 2013—2014 because the “cliff” is averted, but failure to close output gaps in the latter half of the decade lead to mammoth economic losses—all without the economy ever entering official recession.


Under both scenarios, the cumulative output gap would increase by roughly $7.5 trillion over 2013–2022. The rule of thumb that every dollar the economy moves away from potential GDP adds $0.37 to the cyclical budget deficit (via decreased tax receipts and automatic spending on income supports) implies such a sustained depression would increase primary budget deficits by up to $2.8 trillion over 2013–2022, basically increasing budget deficits over that time by roughly one-quarter. And that’s actually the smallest cost of output being depressed below potential, ignoring the substantial long-run economic “scarring” caused by these long spells of idling and depreciating labor and industrial capacity that reduce even the potential for future growth. For example, CBO has lowered its estimate for potential output in 2022 by 1.5 percent as a result of the recession.

Economic growth following financial crises has historically tended to be sluggish. But this is only because it required stronger policy measures than policymakers hampered by conventional wisdom were willing to administer. That we’re failing to heed this clear lesson from history is a tragedy, and, the fact that self-proclaimed deficit hawks are not helping to avoid this trap, even as it may cause deficits in coming decades to swell by trillions, is a depressing commentary on economic policymaking.