A Note on Self-Defeating Austerity and Current Levels of Interest Rates
Joe Gagnon:
RealTime Economic Issues Watch | Self-Defeating Austerity and the Improved US Fiscal Outlook: Last week, Tyler Cowen of the blog Marginal Revolution asked “Have we seen self-defeating austerity in the United States?” Cowen declines to take a clear stand on the question, but his main point is that the well-known fiscal cuts of 2012 and 2013 have, in fact, reduced the US budget deficit. Ergo, goes the implication, austerity was not self-defeating. The problem is that the case for self-defeating austerity—described in a blog post by Paul Krugman and a paper [pdf] by Brad DeLong and Lawrence Summers to which Cowen provides links—focuses on the long-run fiscal impact… fiscal deficits are unusually cheap to finance and monetary policy is not going to move to offset much (if any) of the effects of fiscal policy on the economy….
The relevant question is how much stronger would US economic growth be this year and in future years if the Congress and the administration had delayed tax hikes and spending cuts another year or more. Jackie Calmes and Jonathan Weisman of the New York Times report that private-sector economists estimate that growth would be almost 2 percentage points higher…. At least part of this extra growth would have taken the form of business investment that would have supported durable gains in future economic activity. Even more important, Calmes and Weisman report that unemployment would be about 1 percentage point lower. Many economists believe that allowing people to remain out of work for long periods of time permanently reduces their skills and attachment to the labor force and thus reduces economic output for decades….
We cannot be sure whether the conditions for austerity to be self-defeating are fully met at present, but it is clear that this year’s austerity, and the associated improvement in the US fiscal position, have been achieved only at an enormous price in terms of long-term unemployment and reduced economic growth. And even if this year’s austerity does not make our long-run debt burden heavier, it surely does not reduce it by enough to justify the hardship it has imposed on millions of Americans.
Let's put some numbers to this…
Take the real interest rate on the 30-Year TIP as the price of financing the U.S. government's debt (interest rates probably will rise in the long run, but the overwhelming proportion of the debt is financed at smaller maturities and thus more cheaply than 30 years: these effects about cancel out): that's 0.80% per year. The trend real growth rate of the economy is about 2.7%/year. Thus if we require that the government maintain a stable debt-to-annual-GDP ratio, if we spend enough to boost the debt by an extra $160 billion this year--1% of annual GDP--then if we are thereafter to maintain a stable debt-to-annual-GDP ratio, we need to cut future spending by… wait for it… (0.8% - 2.7%) x 1% = -0.019% of GDP = -$3 billion.
If we spend enough this year to add an extra $160 billion to our debt (which, with a multiplier of 1.5, means we spend an extra $320 billion) and then maintain the debt-to-annual-GDP ratio, we get to spend an extra $3 billion in every future year. At current interest rates, running up the debt does not reduce but rather increases the amount that the government in the future can spend to provide for the general welfare.
At current interest rates, we are way, way, way, way, way, way, way off into the quadrant where austerity is self-defeating.
Of course, Tyler Cowen might say, interest rates won't stay at their current levels forever. But why won't they? As long as employment remains depressed as a share of the adult population, why shouldn't they?
