More than five years after the start of the Great Recession in December 2007, the U.S. economy is still mired in a depressed state of output, and economic growth has decelerated below rates needed to bring us out of this slump. But our current macroeconomic policy — driven entirely by a contractionary fiscal approach — is poised to further slow near-term growth and delay recovery. What is needed at the moment is renewed pursuit of an expansionary fiscal policy in order to restore full economic health. The signs calling for additional targeted stimulus and cautioning against austerity are all there, if only policymakers would recognize them.
History and international experience teaches that policymakers must fight deep economic slumps until they are ended. We cannot afford to repeat the “Mistake of 1937,” when policymakers prematurely withdrew fiscal and monetary support, pushing the economy into a steeper contraction than experienced during the Great Recession.
This lesson has not been heeded on the other side of the Atlantic, and the results of prematurely pulling back fiscal support have become unambiguous. Austerity measures pushed the United Kingdom back into recession in late 2011, and the U.K. economy has contracted in five of the nine quarters through the end of 2012. Japanese Prime Minister Shinzo Abe, on the other hand, recently announced a large infrastructure stimulus program and is pressuring the Japanese central bank to loosen policy to get the economy out of its prolonged slump. But Japan is trying to exit from an adverse equilibrium of slow, saw-toothed growth, big deficits, disinflation, and low interest rates that has lasted roughly two decades — and which is widely attributed to past self-induced macroeconomic policy failures.
Since emerging from recession in July 2009, the United States has outperformed our austerity-infatuated peers in the advanced world. Regrettably, though, many U.S. policymakers are increasingly turning a blind eye to the mounting international evidence and historical experience — as well as an overwhelming consensus of economic research — that austerity wreaks havoc on depressed economies. And the opportunity costs of prolonging this depression are staggering.
This seemingly willful ignorance of facts by some members of Congress has been demonstrated by the recent expiration of the payroll tax cut, the tightening of discretionary spending caps, and the decision by Republicans to allow the automatic sequestration cuts to take effect last week rather than accept any offsets that include a penny of increased revenue. (Blame for economic policy malpractice is not equally shared by both parties — GOP obstructionism has objectively undermined economic recovery in numerous ways over the past four years. And while it’s true that tax increases are contractionary, the fiscal multiplier for government spending is about four to seven times higher than that for a tax increase, so the more the composition of austerity is shifted toward tax increases – particularly progressive ones – the less overall damage.)
Indeed, the fundamental economic challenge posed by the “fiscal cliff” was that of overly rapid deficit reduction, which the lame-duck budget deal actually exacerbated, relative to current policy. And by prematurely pulling away fiscal support, U.S. policymakers risk condemning the economy to a sadly sustainable mix of anemic growth, depressed output, low interest rates, big cyclical budget deficits, high unemployment and gradually squandered long-run economic potential.
Perhaps John Maynard Keynes’s most important insight in his magnum opus, The General Theory of Employment, Interest and Money, is that economies can settle into multiple equilibria (as opposed to the single, full-employment equilibrium of the classical theory). Keynes concluded that government policy is sometimes necessary to boost effective demand and move the economy to a healthier equilibrium, particularly when — as today — a glut of savings persists (at the expense of demand) despite low interest rates. That’s what economists refer to as a “liquidity trap.”
Today, the U.S. economy is in just such an adverse equilibrium, with output depressed $985 billion (5.9 percent) below its potential — what the economy could produce with higher, but noninflationary, levels of employment and industrial capacity utilization. The economy has been depressed at least 5 percent below potential for four years now, and cumulatively has forgone $4.5 trillion in national income to date, with another $2.8 trillion of lost income built into the Congressional Budget Office’s (routinely optimistic) forecast.
Achieving full economic recovery will require faster economic growth than that which has characterized the recovery, and much faster than growth than is projected for 2013.
The U.S. economy’s potential output at full employment naturally rises with increasing population and productivity, growth the Congressional Budget Office (CBO) estimates will average 2.1 percent over the next decade. So making progress toward full employment requires faster growth than this rise in the economy’s innate potential. Problematically, real economic growth has averaged only 2.1 percent since emerging from recession mid-2009, and growth has decelerated to 1.9 percent since mid-2010, after the boost from the American Recovery and Reinvestment Act had peaked. Growth slowed further to 1.6 percent in 2012, and CBO’s latest forecast projects real GDP growth of just 1.4 percent in 2013. As a result, the U.S. economy is projected in 2013 to move further into depression relative to potential output.
This economic forecast showcases the results of the misguided framing and resolution of the “fiscal cliff” debate and the more recent sequestration fight. Near-term deficit reduction intrinsically works against restoring full employment, and obsessing with medium- to long-term deficit reduction diverts policymakers’ focus from the jobs crisis at hand.
The threat that future deficits will decrease future livings standards is not imminent. Meanwhile, our current sustained depression is sinking actual living standards, both present and future. Emphasis on long-term deficit reduction also has a sneaky habit of producing premature near-term austerity.
How can policymakers expect any of their recent actions to break us free from this slow growth, high unemployment equilibrium?
Since the onset of the Great Recession, CBO’s economic forecasts have consistently shown full recovery roughly four to five years away. Currently, CBO forecasts that real GDP growth will accelerate to 4.0 percent annually (or roughly twice trend growth) over the years 2014 to 2016. That would be enough to restore full employment by 2017 — but only if this acceleration materializes.
CBO has routinely issued premature expectations for full recovery: It was projecting full recovery by 2014 when it issued its January 2010 forecast, recovery by 2016 in its January 2011 forecast, and recovery in 2017 in its January 2012 forecast. The modeling assumptions behind those forecasts are common and often reasonable, but the most powerful healing mechanisms are monetary policy, which is ostensibly maxed out, and fiscal policy, which is pushing us in the wrong direction.
The United States does face an unsustainable long-term fiscal trajectory driven by rising health-care costs and inadequate revenue; deficit reduction will eventually be needed, but timing is everything. Today, deficit reduction is particularly damaging per dollar — aptly demonstrated by the United Kingdom — and premature deficit reduction could keep the economy mired in its current state. If fiscal policy is instead used to push the economy fully out of this slump, then subsequent fiscal retrenchment will be much less damaging per dollar than today’s austerity.
It is also true that policymakers need pursue only a temporary fiscal expansion to push the economy back to a virtuous cycle, instead of propping up demand indefinitely. When the economy is back to full health, the Federal Reserve will raise interest rates to cool demand-side inflationary pressures, and conventional monetary policy will once again be able to cushion fiscal contraction. And at full employment, reducing structural budget deficits will lower interest rates through market forces, thereby increasing private investment and cushioning decreased demand from government.
So, how much expansionary fiscal policy would it take for U.S. policymakers to ensure full economic recovery? A new Economic Policy Institute paper estimates that roughly $600 billion to $700 billion worth of deficit-financed, high bang-per-buck fiscal support would be needed in 2013 alone to close the output gap. Somewhat more support would be needed in subsequent years to counteract any demand shortfall due to the deficit reduction imposed by the Budget Control Act. An estimated $1.5 trillion to $2.2 trillion would be needed over the next three years, before a new virtuous cycle was humming and the Federal Reserve could begin raising interest rates. Put differently, policymakers would need to enact deficit-financed fiscal stimulus two to three times larger than the Recovery Act.
Given the misplaced emphasis on deficit reduction since 2010 — $3.1 trillion worth of austerity was enacted in the 112th Congress, including sequestration (policy savings excluding reduced debt service) — this is obviously politically impossible. Policymakers are refusing to even discuss a guaranteed return to full employment, abdicating government’s social compact to target full-employment that had prevailed since the Great Depression.
Allowing productive economic resources (both people and capital) to sit idle and atrophy is exceptionally inefficient. Bouts of depression leave economic scars, and estimates of long-run U.S. economic potential are already being revised downward because of the sustained state of depressed economic activity. CBO’s forecast implies that forgone national income resulting from this depression will rise to $7.3 trillion by 2017, but as noted, their projections are consistently over-optimistic. If trend economic performance is instead sustained, an additional $8.4 trillion of national income may be lost by 2022. This would also mean that cyclical budget deficits persist, likely adding between $1.8 trillion and $3.5 trillion to budget deficits over the next decade, relative to forecasts.
For those expressing concern about public debt, a smaller economy would make nominal debt less sustainable; should the economy remain depressed 5.9 percent below potential a decade from now, the debt-to-GDP ratio would be forced up 6.3 percent, everything else being equal. Better Congress take out an insurance policy against such monumental economic waste.
Ensuring a rapid return to full economic health using borrowed money is actually fiscally responsible — austerity will simply replace structural budget deficits with bigger cyclical deficits, and a poorer nation will have a harder time sustaining its debt. By boosting the economy and shrinking the cyclical deficit, efficient deficit-financed stimulus would even presently reduce the debt-to-GDP ratio. Accepting bigger budget deficits to boost demand is the only means of guaranteeing a full recovery as opposed to banking on its emergence perpetually four years away.