NC Budget and Tax Center

Austerity Fails Again: 2 major blows this week to the case for federal budget cuts

It’s been a tough week for proponents of austerity economics—the misguided notion that government spending cuts and debt reduction magically produce economic growth. First, a team of respected mainstream economists completely discredited one of the foundational studies supporting the claim that excessive public debt holds back economic growth. Then, the International Monetary Fund—formerly a bastion of austerity economics—warned the United States that its budget cuts (including sequestration) had gone too far and would likely damage the nation’s economic growth.

Essentially, these developments repudiate the idea that high levels of public debt hurt economic growth along with the fantasy that cutting government spending help economic growth. Altogether, it’s been a bad week for austerity, as we can see below the fold….

In the first piece of bad news for deficit hawks, a team of mainstream economists succeeded in replicating—and completely discrediting—a highly influential study conducted by Carmen Reinhart and Kenneth Rogoff in 2009. The original piece looked at countries’ economic growth and debt-loads from 1950-2000 and made the claimwidely repeated by proponents of debt-reduction-through-budget-cuts—that countries with a national debt in excess of 90% of GDP experienced a catastrophic slow-down in economic growth, often tipping into recession.

After crunching the same numbers, the team discovered that Reinhart and Rogoff’s remarkable conclusion about debt and economic growth was based on a computational error made in the original authors’ excel spreadsheet.  Apparently, the original paper actually excluded from their analysis three countries that experienced fast economic growth at the exact same time their debt-levels exceeded the supposedly magic line of 90% of GDP—Canada, New Zealand, and Australia during the period 1946-1950.

Once these countries were included and the spreadsheet error corrected, it turns out that countries with a national debt equal to 90% of GDP grew at 2.2% per year instead of the -0.1% projected by Reinhart and Rogoff.  (Click here for a great graphical depiction of the corrected relationship between debt and GDP growth (courtesy of Jared Bernstein).

Oops.

At a more fundamental level, the Reinhart and Rogoff paper was also found to have ignored the unique historical contexts of each different business cycle in each different country—in effect ignoring how different types of recessions in different economies produce different results in growth and debt loads. This glaring oversight led Reinhart and Rogoff to assume that high debt loads reduced economic growth, without considering the reverse—that slow-downs in economic growth often generate greater debt loads, as attention to the historical record (especially the case of Japan) would have made clear.

Taken together, these problems completely discredits this key piece of evidence used to support austerity. If a debt-load in excess of 90% of GDP doesn’t meaningfully reduce economic growth over the long-term, then the notion of a looming American debt crisis completely vanishes. And so does the economic justification for deep budget cuts.

Secondly, at the same time as a key pillar for austerity economics collapsed, the IMF gave the whole approach another blow on Tuesday. In in the biannual World Economic Outlook, the IMF pointedly referenced the failed austerity experiments in the Eurozone and warned the United States  that deep cuts to government spending in the middle of the ongoing sluggish recovery is a bad idea.  As reported in the NYT yesterday,

The I.M.F. said that the United States had proved too aggressive in carrying out budget cuts, given its still-sluggish rates of growth and high unemployment levels. It said it anticipated that the across-the-board $85 billion in budget cuts known as sequestration would push down growth levels this year and beyond.

So not only does high levels of public debt NOT hurt economic growth, but excessive cuts to government spending–the “medicine” for “fixing the debt” most favord by proponents of austerity economics–turn out to be the real source for slowing down economic growth.

In light of these two different developments, the lesson for this weeks is that attempting to reduce the federal debt through deep cuts to government spending will not only yield no positive results in terms of economic growth but will instead produce the opposite result—slower growth, fewer jobs, and less prosperity.

3 Comments

  1. Doug

    April 19, 2013 at 2:36 pm

    All this talk on reducing the growth in spending by a measly $80-100 billion per year. You cannot convince me that the federal government will not function with those cuts that were what, 1% of the growth? The fact is, we are bankrupt and now are spending more per person per year than said person makes. This a passage from John Mauldin:

    In fiscal 2010, according to numbers published by the Census Bureau and the Office of Management and Budget (OMB), net spending by all levels of government in the United States was $5,942,988,401,000. That equaled $50,074 for each one of the 118,682,000 households in the country.
    In that same year, according to the Census Bureau, the median household income was $49,445. That means total net government spending per household ($50,074) exceeded median household income (49,445) by $629… As recently as 2000, the relationship between government spending and household income was dramatically different. Data from the Census Bureau and the OMB show that in that year net spending by all levels of government was 3,239,913,876,000. That equaled $29,941 for each of the nation’s then 108,209,000 households. In 2000, the median household income was $41,990… (A very interesting e-book called Completely Predictable)

    We are on a quick path to the bond markets making the austerity decisions for us, when you are spending more than what the average of income is across the nation it will not last. And for the US, it will be much harder on the country and world than Greece.

  2. Allan Freyer

    April 19, 2013 at 2:55 pm

    And yet, Doug, the IMF disagrees with you.

    Look, it’s entirely possible to make a philosophical argument that government is too big and needs to be reduced, but the economic case for cutting government spending in the middle of a tough recovery just doesn’t have much empirical evidence to support it.

    Context-free caluclations of government spending per household (measures I’ve never seen in the economics literature) don’t really do anything to provide empirical support for the idea that government spending is harmful to economic growth.

  3. Doug

    April 22, 2013 at 2:35 pm

    Allan,
    You have to be careful putting too much stock in economists and complex spreadsheets. Overall their story remains the same, maybe the trigger has changed somewhat, but it is still the same story.

    But in any case, whether in their original work or in the later paper, they describe a problem with excessive debt that is true on average. Actual experience shows that in some countries debt will create a problem at quite low levels, while Japan climbs toward 250% debt to GDP (and will get there all too soon) and hardly anyone blinks. Be aware though, there is a mythical line where confidence and trust is lost, but no one knows where that line of demarcation is until it is crossed. And right up until the last minute, there are always those who look for ways to add more debt, who say to us, “This time is different.” But it never is. Eventuallty you get that BANG! moment where the rug is pulled out from under you. It is almost irrelevant whether that number is 90% or 120% or 80%. It will be a different number for each country, depending on the confidence that investors have in the ability of a country to pay back its debt. When that moment happens, you better watch out for forced austerity.

    Me, I would rather assume the percentage below the actual bang moment is where we need to start thinking about it. Rather austerity to get our house in order and make reasoned choices than a forced austerity that really really hurts in places people really need.