Tax Analysts Blog

Does the Economy Need Stimulus or Austerity? Yes.

Posted on Sep 24, 2013

For years now, Washington has been saturated with arguments about stimulus and austerity. Or more precisely, stimulus or austerity, because in Washington, you can’t support both. You’re either a free-spending liberal or a tight-fisted conservative – no fence sitting allowed.

In fact, however, the stimulus-austerity debate hinges on a false dichotomy. Both are plausible and even prudent approaches to fiscal policy. But only when practiced in sequence -- something lawmakers usually fail to do.

Ideally, political leaders pursue expansionary fiscal policy in recessions and restrictive fiscal policy during booms. British economist John Maynard Keynes is widely credited with inventing this policy prescription, but he was hardly the first to suggest that government spending might jumpstart the economy. As I recounted in a 2010 article, that idea was already old in 1936 when Keynes published his magnum opus, The General Theory of Employment, Interest and Money.

But Keynes refined and popularized the virtues of countercyclical fiscal policy. Ever since, political leaders in both parties have accepted his advice -- in practice if not in theory.

Currently, the Keynesian prescription calls for short-term stimulus followed by medium-to long-term fiscal consolidation. Even many conservative economists recognize the virtues of such an approach. In July, for instance, Harvard economist Martin Feldstein suggested it to European officials:

Europe needs three things,” Feldstein wrote. “Structural changes to boost long-run potential gross domestic product, a short-term stimulus to increase employment, and a commitment to longer-term spending reductions to shrink the national debt.”

What’s good for Europe would be good for the United States, too. “The right policy bargain,“ wrote another Harvard economist, Jeff Frankels, last month, “is fiscal stimulus in the short term, not fiscal contraction, combined with steps today to address the entitlements problem in the long-term. That would get us back to solid growth. Our current pattern of pro-cyclical fiscal policy is exactly backwards.”

In fact, our current fiscal policy isn’t just a backwards, but dangerous, too. Mistimed austerity (chiefly but not only in the form of the sequester) has already slowed growth and delayed recovery. As Kevin Drum explained recently in Mother Jones:

    This difference between actual GDP and potential GDP is called the "output gap," a bloodless term that represents a great deal of real-world pain. If we had spent more in order to close the output gap faster, it would have meant more jobs—perhaps as many as 3 million more—higher wages, healthier retirement accounts, and, ironically, a shrinking deficit thanks to higher tax revenues and lower spending on food stamps, Medicaid, and other programs for the poor.

Europe, of course, provides another cautionary tale on the dangers of ill-advised austerity (even if leading EU officials don’t seem to think so). At this point, believing that austerity is the best prescription for recovery requires a wanton disregard for all the evidence at hand.

And yet, plenty of people are still committed to short-term austerity. The serial crises slated to unfold in Washington over the next few weeks – September’s fight over the continuing resolution followed by October’s drama over the debt ceiling – all hinge on issues of short-term spending, not long-term adjustments to the nation’s expensive entitlement programs.

And that’s just plain crazy. Under no scenario is cutting fiscal 2014 spending going to make our long-term problems better. In fact, by hindering recovery and discouraging employment, they will make them worse.

Which is why austerity critics have been so vocal in resisting the drive to slash spending. They decried the 2011 debt limit deal that gave us sequestration, and they are currently struggling to fend off any further cuts. The argument for austerity, they insist, has traded on a sort of budget hysteria. As Paul Krugman wrote in 2012:

    At every stage of our ongoing economic crisis — and in particular, every time anyone has suggested actually trying to do something about mass unemployment — a chorus of voices has warned that unless we bring down budget deficits now now now, financial markets will turn on America, driving interest rates sky-high. And these prophecies of doom have had a powerful effect on our economic discourse.

Doomsday has yet to arrive, and the anti-austerians are inclined to think it never will – or at least not for decades. Recent projections from the Congresisonal Budget Office have encouraged that sort optimism. “This is not a crisis,” Krugman wrote. “It’s not even a picture of a crisis. The new CBO long-term budget projections are out, and while they’re not good, they don’t show crisis levels of debt even looking out a quarter-century.”

Krugman is right; near-term debt hysteria is clearly misplaced. But it’s a short step from calling out conservatives to comforting the complacent. Ignoring long-term fiscal problems because they are not sufficiently disastrous carries its own dangers. “Small reasons to refrain from hard choices are never wasted in Washington,” wrote former congressman Bill Frenzel last year in Forbes. “Inaction marches on.”

Sadly, that observation is spot-on. It seems highly unlikely that anyone in Washington is going to do anything about the nation’s long-term fiscal challenges, if only because they don't seem challenging enough.

Even worse, it’s likely that lawmakers will continue their pursuit of short-term austerity, either through a continuation or even an enhancement of the existing sequester.

By late fall, Americans will be the unhappy victims of a terrible sort of compromise, one that combines long-term complacency with short-term hysteria. Together, that package should do a fine job of hobbling the nation’s economy for years to come.

And you thought things couldn’t get any worse.

Read Comments (1)

amt buffSep 25, 2013

If there were a way to lock in long-term austerity, it would become possible to
reach a compromise on short-term policy.

Unfortunately the only known way to enforce austerity is a default which ends
the government's ability to borrow. That will be horribly painful,
progressively more painful the later it occurs.

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