Recently, barely-perceptible cracks have started to appear in the political foundations of austerity. Prominent Democrats on Capitol Hill—not just progressives but moderates and those who have embraced the administration’s pursuit of a “Grand Bargain” on deficit reduction—have recently called for an implicit time-out on fiscal tightening. Some European policymakers have similarly argued that austerity has gone too far. And prominent financial market players have warned that the United Kingdom should reverse its rapid drive towards austerity. Perhaps most surprisingly, even John Makin from the conservative American Enterprise Institute has called for an end to tightening.
It’s about time. The intellectual foundations for austerity have always been fragile. The recent controversy that erupted over a group of University of Massachusetts economists highlighting the extreme weakness of an oft-cited justification (pdf) for keeping debt ratios below 90 percent is just the latest demonstration of this. The UMass paper was important, but is only the latest and most well-known of the many refutations (pdf) of the case (pdf) that contractionary fiscal policy would produce (pdf) anything but contraction in today’s economy.
The most useful political correction that could follow this wider recognition of the extraordinary dangers of premature austerity would be a cessation of the ten-year deficit targets that have polluted the policy debate in recent years. Earlier this week, the Economic Policy Institute and The Century Foundation released a briefing paper detailing why fixation on 10-year deficit reduction targets will almost certainly result in bad policy outcomes; the emphasis on top-line savings in these targets skates over more-important issues related to timing, composition, debt dynamics and political viability of upfront stimulus:
- Timing: Stabilizing the debt ratio when the economy is at or near full-employment is a perfectly sensible rule, but one that is irrelevant to today’s economic debate: the economy remains deeply depressed more than five years after the onset of the Great Recession. Nearly all policy proposals based on ten-year deficit reduction targets that invoke this rule—including the administration’s—imply fiscal tightening that begins far too soon (a notable exception is the Congressional Progressive Caucus’s Back to Work budget). This premature tightening will just forestall a full recovery that is already taking far too long to appear.
- Composition: Because today’s economy is weak due to deficient demand, the economic and even the net fiscal impact of austerity hinges on specific policies’ (widely varying) effect on economy-wide spending. 10-year deficit targets generally ignore these compositional concerns, particularly the stark difference between spending cuts that drag heavily on economy-wide demand and tax increases (particularly those on high incomes and corporate earnings) that do not provide such a heavy drag. In our paper, we show that in fiscal 2013 any deficit reduction driven by savings based on policies with a multiplier over 0.9 would increase the debt ratio, while any policy with a multiplier below 0.9 would reduce the debt ratio. This means spending cuts would increase near-term debt ratios, while progressive tax increases would reduce the debt ratio. Hence, it matters greatly what the composition of any fiscal policy package looks like, and this crucial component is ignored by those simply calling for overall 10-year savings.
- Debt dynamics: When austerity reduces economic output, two channels actually exert upward pressure on the debt ratio: a shrinking denominator (GDP) and increasing cyclical pressure on budget deficits (lower tax receipts and increased automatic stabilizer spending, e.g. unemployment insurance). When the economy is as extraordinarily weak as it is today, these effects can offset or even swamp the reduction in deficits driven directly by policy savings, leading to a rise in the debt ratio following austerity measures. Holland and Portes (2012) have concluded that European austerity has indeed raised debt ratios over 2011-2013: “In both the UK and the Euro Area as a whole, the result of coordinated fiscal consolidation is a rise in the debt-GDP ratio of approximately 5 percentage points.” Our paper points out that these results would almost surely carry over to the United States as well.
- Stimulus: Promoting a 10-year net deficit reduction target makes getting upfront stimulus much harder, because a fixed 10-year number for deficit reduction necessarily implies that the fiscal costs of stimulus would require greater offsetting deficit reduction in later years. But there is no economic justification for insisting that near-term stimulus be offset later in the budget window. Our paper shows that the only compelling reason to insist that upfront stimulus be “paid for” within the ten-year budget window is if there is identifiable economic damage caused by the debt ratio exceeding some well-defined “threshold.” But evidence for such a threshold (particularly for the United States) has always been weak—as the recent controversy over the Reinhart and Rogoff (2010) paper has shown.
After avoiding aggressive European-style austerity while its policy merits were being debated among academics in 2010-2011, U.S. fiscal policy is now on auto-pilot to follow Europe down the austerity rabbit hole. Perversely, this course has been set after the intellectual case for austerity, always weak (pdf), has reached its nadir. Austerity measures in 2013 include the expiration of the payroll tax cut, blunt sequestration spending cuts and the ratcheting down of discretionary spending caps. The fiscal headwind imposed by these cuts—layered on top of state and local government austerity that has dragged on growth for 13 of the past 14 quarters—is considerable. Despite the sizable federal fiscal retrenchment that has already been enacted over the last two years—and prematurely set to escalate substantially in 2013—far too many in DC, including, unfortunately, the Obama administration continue to propose additional 10-year deficit reduction targets. It’s a good thing that that austerity for austerity’s sake is coming under renewed scrutiny on both sides of the political aisle as well as both sides of the Atlantic. It’s time to change policy to reflect this improved understanding.