Roving thoughts and provocations

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The Sequester’s Hidden Danger

Felix Vallotton

The sequester is dangerous, but not for the reasons we think. Contrary to what some alarmists predicted, there is little evidence that the automatic, across-the-board cuts to the US budget that went into effect on Friday are causing cataclysmic harm. The stock market has risen slightly to near record heights, and most economists agree that the $85 billion down payment this year on about $1 trillion in cuts over the next ten will not trip the economy into recession. Recent polls, meanwhile, indicate that a large part of the electorate has no opinion on the sequester, which is still poorly understood—making it perhaps less of a political liability for either party than some anticipated.

But what makes the sequester threatening is not that it will plunder the economy in 2013. Rather, it is that these arbitrary cuts are exactly the opposite of what the economy needs both in the short run, and—if the promised $1 trillion in further cuts over ten years is made—in the long term. In the coming months, it will make it difficult for the president to cut the unemployment rate from current levels around 8 percent, a fact that Republicans must enjoy since it reduces their chances of losing the House in 2014, and raises their chances of winning the presidency in 2016 if they can continue to cut spending.

And the sequester will be painful. Educational and housing subsidies will be cut, as will unemployment insurance and research spending. More than $40 billion will be cut from the defense budget, music to my ears, but not to those who will lose jobs at defense contractors. Above all, claims that economic growth down the road will be spurred by reducing the federal deficit through spending cuts are not credible.

Indeed, the real danger of the sequester lies in the misguided deficit-cutting mania that created it in the first place. Put in place by Congress with the president’s approval and encouragement in 2011, the idea of automatic sequestration came out of the same obsession with austerity measures that has put much of Europe into recession and prevented the US economic recovery from fulfilling its potential. Deficit reduction has wide support in Washington and its most active promoters are financed by some of the nation’s wealthiest citizens, who argue that it is a far better alternative than asking them to contribute more in taxes. We must cut deficits now, even before we have a full economic recovery, the thinking goes, to deal with rapidly rising healthcare costs that will drive up the government’s Medicare and Medicaid expenses beginning twenty-five years from now.

This approach to economic policy has no sound basis in either historical experience or current economic analysis. Washington’s austerity economics—the notion that you can induce economic recovery in a weak economy simply by cutting government expenditures—willfully ignores, denies, or declares nonsense the true lessons of the Great Depression, which demonstrated precisely the opposite. More or less since Adam Smith, economists had argued you must increase savings to increase investment, which in turn drove economic growth and produced rising incomes. One way to do this is to get federal deficits down as a percent of GDP. But in the 1930s, it was clear that government efforts to save money had not prevented the global economy from tumbling into severe depression. To the contrary, they helped create the depression of the early 1930s and then a second major downtown in 1937. This is around the time that John Maynard Keynes had the dramatic insight that it wasn’t savings that led to investment but the other way around: more government spending raises incomes and therefore savings, from which more investment is made.

It is true that Keynesian stimulus was derided by economists beginning in the 1970s. Only monetary stimulus—that is, cutting interest rates—was thought to matter. But now rates have been brought so low that they do far less than hoped. And in truth there has been a growing recognition that monetary policy is not by itself adequate to assure a strong economy. Meantime, a “new” Keynesianism developed among some but by no means all mainstream economists, who support the view that modest government stimulus is sensible. But this general approach is a pallid version of the original and still holds, I think too strongly, that reducing deficits is necessary to assure adequate savings.

We need not go back to the Great Depression to understand the dangers of austerity and deficit mania. In our own time, the abysmal performance of austerity-bound European economies have demonstrated the same problem. Take the case of Britain. After the recent global economic crisis, David Cameron, Britain’s Conservative Prime Minister, and George Osborne, his absurdly overconfident chancellor of the Exchequer, repudiated Keynes’ central insight. Two years ago, with the British economy just coming out of recession, these men raised taxes and cut social spending in order to reduce the British deficit and, they claimed, enable newly confident businesses to use all that savings to invest and re-charge the economy. It was pure anti-Keynesianism. The chancellor promised that the budget deficit would fall nicely as a percent of gross domestic product. Thus, a path would be cleared for more capital investment by otherwise “crowded out” private companies.

None of that has come close to happening. Britain is now probably entering its third recession since 2009. With such slow growth, tax revenue is dismal, and the country’s deficit, excluding interest payments, remains the highest, by percentage of GDP, of any European nation. And what of all that promised investment that was predicted? Not only did a chunk of new savings fail to materialize, capital injections in the economy have been weak. They contributed only 0.4 percent to economic growth in 2012, half of the government’s forecast. As for exports, which the government also insisted would rise as the value of the pound fell, the nation’s current account deficit, the excess of its imports (plus investment income) over exports, is now no better than in 2009.

Despite these dismal results, the British citizenry apparently still think the policies are sensible. They have not thrown Cameron and Osborne out. But what is driving Britain’s growth is consumer spending and government spending, not business investment and exports as the austerity advocates forecast. And consumer spending alone is just not strong enough to produce adequate growth. It is Keynes who was right, not Osborne. Meanwhile, economies in Europe’s southern tier, including Spain, Portugal, Italy, and Greece, are mired in recession.

These policies are an appalling intellectual failure. Yet our current leaders in Washington seem unable to learn this lesson, even in the face of such stark examples of Britain and other European countries. Though he backed the stimulus in early 2009, Barack Obama had already displayed a sympathy for deficit reduction policies before he took office, and he subsequently appointed the Bowles-Simpson commission to suggest ways to balance the budget as soon as possible. He did not accept their proposals, but the austerity advocates quickly gained the upper hand.

Many may wonder why it is so easy to renounce the remarkable Keynes. In part, it is because he so deeply challenged Smith’s Invisible Hand itself, that almost religiously held principle that markets themselves are self-adjusting as prices change to make demand and supply equal.

We all know that austerity economics rules in Europe, but it also rules in the US where the damage done will be considerable if less obvious. Even policymakers who are sympathetic to Keynesianism for the most part propose only moderate stimulus. As a result of Washington’s refusal to raise taxes to cut deficits, the government will not invest adequately in infrastructure, green technologies, public research, pre-k education, and in many other areas of critical need—all in order to meet spurious deficit cutting goals. It also finds expression in a greater willingness to cut needed programs, mostly for the poor, who will suffer as a result. At some point, such mean-spiritedness must take a toll on a nation’s moral confidence. And the budget battles may only just be beginning.

The economy would have been significantly stronger already had there been not been $1.5 trillion in earlier budget cuts. And it may yet improve once we digest the latest round of cuts. But let’s not mistakenly attribute future improvement in the economy to austerity policies. It will be in spite of them.

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