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Self-Defeating Austerity and the Improved US Fiscal Outlook

by | May 24th, 2013 | 11:23 am
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Last week, Tyler Cowen of the blog Marginal Revolution asked “Have we seen self-defeating austerity in the United States?” Cowen declines to take a clear stand on the question, but his main point is that the well-known fiscal cuts of 2012 and 2013 have, in fact, reduced the US budget deficit. Ergo, goes the implication, austerity was not self-defeating.

The problem is that the case for self-defeating austerity—described in a blog post by Paul Krugman and a paper [pdf] by Brad DeLong and Lawrence Summers to which Cowen provides links—focuses on the long-run fiscal impact. Both accounts concede that austerity reduces the deficit in the short run. Their argument is that in the current environment of near-zero interest rates, fiscal deficits are unusually cheap to finance and monetary policy is not going to move to offset much (if any) of the effects of fiscal policy on the economy. Under these conditions, it is indeed possible that austerity today may reduce future tax revenues by so much that the national debt ends up larger than it would have been without austerity.

The relevant question is how much stronger would US economic growth be this year and in future years if the Congress and the administration had delayed tax hikes and spending cuts another year or more. Jackie Calmes and Jonathan Weisman of the New York Times report that private-sector economists estimate that growth would be almost 2 percentage points higher. A growth rate of around 4 percent is consistent with historical norms for recovery from a deep recession; the current rate of around 2 percent is abnormally low given the large excess capacity in the economy.

At least part of this extra growth would have taken the form of business investment that would have supported durable gains in future economic activity. Even more important, Calmes and Weisman report that unemployment would be about 1 percentage point lower. Many economists believe that allowing people to remain out of work for long periods of time permanently reduces their skills and attachment to the labor force and thus reduces economic output for decades.

The case that austerity is self-defeating hinges on the long-lasting reduction in tax revenues associated with the lower economic growth caused by austerity. In the current unusual circumstances, it is possible that this year’s austerity will reduce future economic activity by so much that the decline in future tax revenues will ultimately outweigh any near-term reduction in our national debt, leaving national debt even larger relative to the US economy than if the austerity were delayed to a period of lower unemployment and higher interest rates.

We cannot be sure whether the conditions for austerity to be self-defeating are fully met at present, but it is clear that this year’s austerity, and the associated improvement in the US fiscal position, have been achieved only at an enormous price in terms of long-term unemployment and reduced economic growth. And even if this year’s austerity does not make our long-run debt burden heavier, it surely does not reduce it by enough to justify the hardship it has imposed on millions of Americans.