A Rising Deficit Isn't the U.S. Economy's Worst Problem

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The Covid-19 pandemic will eventually subside, but the economic hangover from the recession it brought will be long and painful. As calls grow for government to step up and spend money in order to get the economy back on its feet, deficit hawks already are raising their voices in response. Hastening the post-Covid recovery will require overcoming the doctrine of austerity, which did so much to hurt the U.S. and other countries during the last recession.

When the financial crisis led to the Great Recession back in 2008, the idea of fiscal austerity was quick to rear its head. A number of prominent right-leaning economists disparaged the notion that government spending could ameliorate the downturn. Some even argued that cutting spending would expand the economy, by increasing confidence in the government’s solvency. Others warned that too much government debt would slow down economic growth.

Ultimately, pro-austerity arguments helped to limit the size of President Barack Obama’s fiscal stimulus, and found an even more receptive audience in some parts of Europe. Austerity  -- helped by the activism of conservative Tea Party Republicans -- won the day, and most of the deficit spending initiated in the early years of the Great Recession was reversed.

The idea of austerity is attractive for several reasons. Many people tend to think of the government as being like a household; a government that borrows to spend is seen as irresponsible. What’s more, conservatives often fear that emergency government spending will become permanent when a recession is over, thus ratcheting up the size of government. Economists who watched crises in emerging markets were long accustomed to recommending that these countries strengthen their fiscal position in order to gain the confidence of fickle international capital. And cynical politicians may invoke austerity in order to prevent a president from the opposing party from giving the economy a boost.

But the U.S. must avoid the siren song of austerity this time around. Theory and evidence both come down strongly against cutting spending in a downturn. And although government borrowing can be bad in some situations, now is not one of those times.

As it turns out, the notion that reducing government spending can stimulate the economy doesn’t have much empirical support. A team of International Monetary Fund economists reexamined the idea in 2011, measuring changes in fiscal policy by looking at direct evidence from government speeches and internal documents. They found that government spending cuts tend to reduce private investment and depress economic activity. The research showing otherwise, they argue, had made a mistake by confusing natural economic forces with changes in government policy.

Meanwhile, the minority of economists who pooh-poohed fiscal stimulus didn’t have much of a leg to stand on. The theoretical justification for spending to boost the economy -- especially in a deep recession, when interest rates can’t be cut past zero -- is as solid as macroeconomic theory ever gets. What’s more, a slew of empirical analyses since 2008 almost all show the effectiveness of fiscal stimulus during recessions. The respected macroeconomist Robert Hall concluded that Obama’s stimulus, modest and short-lived as it was, still managed to cushion about one-fifth of the blow of the Great Recession. Meanwhile, European countries that indulged in austerity performed generally worse than others.

The reason, of course, is that the government isn’t like a household. Though some governments borrow mainly from foreign countries, the U.S. borrows mainly from U.S. bond investors. Since most federal debt is money the U.S. owes to itself, it’s not really being spendthrift when it borrows. The main question is whether private bond investors will continue to finance the U.S. deficit. So far, persistently low interest rates show that they’re perfectly willing to do so.

If interest rates someday rise, the Federal Reserve might have to increase the money supply in order to push them back down, which might create inflation. But the lack of inflation -- even in countries with far more government debt than the U.S. -- means that this point is still probably far off.

What’s more, when the government spends, it often benefits society even if it doesn’t make its money back. Investments in scientific research, infrastructure and education can produce big dividends for the private sector, even though the increased tax revenue might not be enough to pay for the spending. In this case, the debt is always worth it.

So austerity is a false prophet -- at least, during recessions. But false prophets have real power, and this one is already doing some damage. When Congress’ concern over deficits caused special unemployment benefits to lapse, millions of Americans fell into poverty. That's certain to hurt the economy going forward. Meanwhile, a Joe Biden victory in the upcoming presidential election might cause Republicans to dig in their heels against further government action, as they did during the Obama administration. The result would be a human and economic tragedy.

Austerity has its place -- but in good times, not during recessions. Until the Covid-induced downturn is firmly in the rearview mirror, the U.S. government shouldn’t be afraid to spend.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

©2020 Bloomberg L.P.

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