As we approach the end of the calendar year, we are hearing more and more expressions of alarm about the “fiscal cliff,” over which the country could tumble on January 1, 2013. As I will argue below, there is indeed reason to be worried about this cliff; but the reason is actually the opposite of that expressed by many of the alarmists.
The biggest obstacle to a pro-employment policy in the United States today is widespread fear about running federal government budget deficits, which add to the national debt – the sum of all past deficits minus all past surpluses. Most politicians, not only Republicans but also many Democrats, believe that reducing the national debt is now our single most important economic task. So they call for policymakers to focus single-mindedly on reducing the annual federal government deficit. And they have been encouraged in such beliefs by all too many economists.
The kind of budgetary policy being pushed is one of fiscal austerity, as distinct from a policy of fiscal stimulus in which a government deliberately undertakes to spend more than it receives in revenues. Such stimulus calls for government borrowing to finance expenditures in excess of revenues, which increases the national debt in the short run. Nonetheless, there are many reasons why the right fiscal policy is one of stimulus rather than austerity, under current recessionary conditions of continuing high unemployment.
First of all, what is holding back businesses from expanding employment and output in the U.S. is primarily the lack of sufficient demand for goods and services. In recessionary times, with much idle productive capacity and high unemployment, businesses will expand their activity only if they have reason to expect rising demand for their products. By far the biggest source of overall demand is consumer spending; but consumers both at home and abroad are still being weighed down by the adverse impact of the worldwide economic crisis that began in 2008. Most of them are saddled with debt, and many have less purchasing power than before the crisis – if they still have any income at all. Investment spending is also a key source of overall demand, though considerably smaller than consumer spending. Businesses operating in the U.S. have access to plenty of cheap credit with which to invest, as interest rates are at historically low levels, but most firms are holding back because they do not see much likelihood of increased demand for their products.
The one source of overall demand for U.S. goods and services that can be significantly increased under worldwide recessionary conditions is the federal government. Overall demand can be significantly boosted if the government increases its own spending, or if it raises consumer demand by reducing taxation of people likely to use most of any increase in disposable income for consumption. The stimulus package passed by Congress and signed by President Obama in 2009 did both of these things, and this prevented the “Great Recession” in the U.S. from turning into another Great Depression, with a loss of several million more jobs. Because the U.S. economy is still in recession four years later, despite some job growth in the past few years, further stimulus by the federal government is needed to bring about a full economic recovery.
Many of the people who are sounding the greatest alarm about the fiscal cliff these days are using that alarm to push the federal government to pursue a fiscal policy of greater austerity, so as to reduce deficits and stop adding to the national debt. Yet the real problem with the cliff is precisely the opposite. If nothing is done about it, federal government expenditures will decrease significantly, via the “sequestration” of funds otherwise going to domestic government programs and to the military, and federal government revenues will increase significantly, via an increase in taxes on all U.S. income tax payers and the ending of the social security tax reduction. In other words, if we go over the fiscal cliff, the federal government will be pursuing a new policy of much greater fiscal austerity than before. The nonpartisan Congressional Budget Office estimates that going over the fiscal cliff would reduce the growth of U.S. GDP by 3 percentage points in 2013, pulling back the expected growth of employment and output into negative territory and causing the loss of several million jobs.
What we need instead of such an austerity shock is a fiscal stimulus of similar proportions, which can only be achieved by some combination of increased federal government spending, reduced taxation of low- and middle-income earners, and expansion of unemployment benefits.
Such expansionary fiscal policies will of course increase the government budget deficit in the short run, thereby adding to the national debt. But by stimulating the economy to expand employment and output much more than would otherwise be possible, such policies also serve to increase future tax receipts, which will make it easier for the government to reduce its deficit in the long run.
The case for expansionary fiscal policies is all the stronger these days because the interest rates at which the U.S. government can borrow to finance budget deficits have been at historically low levels in recent years. This reflects both strong worldwide trust that the U.S. can be counted upon to pay its bills and the fact that the U.S. economy is still in recession, so that government borrowing does not crowd out private borrowing and thereby push up interest rates. Output and employment in the U.S. will have to rise a great deal over the next few years in order for the U.S. economy to emerge from recession and begin to push up interest rates. Only at that point will it make sense to begin shifting from a policy of fiscal stimulus toward one of more austerity.
Finally, we have strong empirical evidence from Europe that the pursuit of a fiscal policy of austerity under recessionary conditions works to reduce employment and output growth, thereby making it more difficult to reduce national debt. The latest annual World Outlook report by the International Monetary Fund (IMF), released in October 2012, shows that the countries pursing the most austere budgetary polices in recent years – in particular, the biggest spending cuts – are those that have also experienced the deepest economic slumps: Great Britain, Ireland, Spain, Portugal and Greece.
Read the second part of this post, “Why the Deficit Hawks Are Wrong,” next week.