In a recent blog post on the (negligible, if not nonexistent) long-run economic cost of deficit-financed fiscal stimulus at present, I noted in passing that the Congressional Budget Office (CBO) has downwardly revised potential economic output for 2017 by 6.6 percent since the start of the recession. This may seem trivial, but for a $15 trillion economy, this dip reflects roughly $1.3 trillion in lost future income in a single year, on top of years of cumulative forgone income (already at roughly $3 trillion and counting). The level of potential output projected for 2017 before the recession is now expected to be reached between 2019 and 2020—representing roughly two-and-a-half years of forgone potential income. This represents a failure of economic policy and merits considerably more attention than received, especially when weighing the benefit of near-term fiscal stimulus versus deficit reduction.
Potential output is the estimated level of economic activity that would occur if the economy’s productive resources were fully utilized—in the case of labor, this means something like a 5 percent unemployment rate rather than today’s 8.2 percent. Potential output is not a pure ceiling for economic activity, but the level of economic activity above which resource scarcity is believed to build inflationary pressures. As of the first quarter of 2012, the U.S. economy was running $861 billion (or 5.3 percent) below potential output—the shortfall known as the “output gap.” This has a number of implications for federal fiscal policy:
- Deficit-financed fiscal stimulus will have a very high bang-per-buck while large output gaps persist. The government spending multiplier is much larger in recessions than expansions (see Figure 3 of Auerbach and Gorodnichenko 2011) and the U.S. remains mired in recessionary conditions, where economic growth is insufficient to restore full employment.
- Deficit-financed fiscal stimulus is largely self-financing because every dollar of increased output relative to potential output is associated with a cyclical $0.37 reduction in budget deficits, and this feedback effect is greatly amplified by the large government spending multiplier.
- There is so much slack in the U.S. economy—i.e., supply of resources in excess of demand—that government borrowing will not “crowd-out” productive private investment; this can be seen in the near record-low 1.6 percent yield on 10-year U.S. Treasuries.
So deficit-financed fiscal stimulus is highly cost-effective, largely self-financing, has a very low opportunity cost, and poses no risk to inflation. But there is another potential benefit: closing today’s output gap can increase potential future output (thereby also increasing the ability to repay debt incurred). The reason is simple—if long bouts of inactivity leave permanent “scars” on the potentially productive resources (and they do), then the longer the economy operates below potential, the more future potential is damaged. Concretely, factories aren’t built because firms can’t even sell what existing factories are producing. Children’s educational outcomes are damaged as economic distress forces their families to move and as they lose access to decent nutrition and health. Desirable early-career jobs for recent graduates that could impart valuable skills throughout their working lives aren’t available to them, so lifetime earnings suffer. And so on.
The CBO certainly is worried about this scarring—look at the annual revisions to real potential GDP made by them since the onset of the recession: Estimates have consistently been revised downwards except between Jan. 2009 and Jan. 2010, when the deficit-financed $831 billion Recovery Act arrested economic contraction and began shrinking the output gap.
The Recovery Act, however, was nowhere near large enough to restore full employment and close the output gap—the 10-year cost of the stimulus, after all, was smaller than the annual output gaps that have persisted since 2009. As the economy has slowed as fiscal support waned, CBO’s potential output forecasts have withered as well. So why did Congress pivot from job creation (i.e., stimulus) to deficit reduction at the start of the 112th Congress?
The whole point of long-term deficit reduction, after all, is to raise future income. But failure to restore full employment decreases potential future income. Worse, while the economy remains depressed below potential output, near-term deficit reduction—particularly spending cuts—greatly exacerbate the output gap because the government spending multiplier is so high. (We’ve seen this play out across much of Europe, where government “austerity” programs have cut spending, pushed economies back into recession, pushed up unemployment, and cyclical deterioration in the budget deficit has rendered spending cuts entirely counterproductive.)
The downward revisions to potential output in CBO’s forecast reflect a failure of Congress to resuscitate the economy and restore full employment, but it’s a policy failure that can still be reversed. Fiscal stimulus can increase employment and industrial capacity utilization today and actually “crowd-in” private investment, thereby increasing today’s capital stock and future potential output. With respect to fiscal tradeoffs, cost effective deficit-financed fiscal stimulus will actually decrease the near-term debt-to-GDP ratio (the relevant metric for fiscal sustainability), whereas deficit reduction cannot raise future income until the output gap is closed and the private sector is competing with government for savings instead of plowing cash into Treasuries. The full cost of Congress’ misguided pivot from job creation to austerity is larger than even just today’s mass underemployment—trillions of dollars of potential future income will also be lost unless we pivot back to addressing the real crisis at hand.