international analysis and commentary

Obama takes the road less traveled


In his latest State of the Union address on February 12th, President Obama attempted to shift the focus of the political system away from deficit reduction and towards economic growth. It’s about time.

There are three reasons why this is a good idea. First, Congress and the President have already enacted $2.5 trillion in deficit reduction over the last two years. Depending on how you measure it, finishing the job of stabilizing the debt would take an additional $670 billion to $1.5 trillion in deficit reduction. Moreover, the budget deficit has been shrinking faster in the last few years than at any time since the demobilization following World War II. We’re making good progress, and there’s just simply not a lot left to do.

Second, deficit reduction can easily be counter-productive. Consider the United Kingdom. Its recent past resembles that of the US in many ways: both countries experienced similarly-sized initial economic shocks, and both countries had central banks that engaged in responses of similar magnitude. And, consequently, the economies of these two countries chugged along at a similar pace between mid-2009 and mid-2010: 2.2% real annualized growth for the U.K., 2.5% growth for the US, according to the OECD.

But in the summer of 2010, the newly-elected conservative-led coalition government of David Cameron passed a massive austerity budget, largely made up of spending cuts (non-health domestic departmental spending took a 25% cut). This budget brought total austerity up to a staggering 6.3% of GDP.

So what happened? The UK economy immediately started contracting, while the US economy continued to grow at the same mediocre-yet-consistent rate. In fact, since the third quarter of 2010, the UK has grown at a real annualized rate of 0.2%, eleven times slower than its previous growth rate and nine times slower than US’ over the same time period.

But more importantly, its debt continued to rise. Since mid-2010, UK public debt (excluding financial assets held by the government) as a share of the economy rose from 55% to 69%. This happened because the economy and the deficit are inextricably linked. A poor economy, one operating below potential output, means a larger deficit: a high level of unemployment both depresses tax revenue and forces more people to rely on the social safety net (e.g. unemployment insurance, Medicaid, food assistance, etc). As an economy expands closer to potential output, the deficit falls because it moves people from the social safety net back into the job force, resulting in lower spending and higher revenues. In fact, from 1969 to 2008, each dollar increase in actual gross domestic product (GDP) relative to potential GDP has been associated with a $0.3768 reduction in budget deficits. In other words, in the name of deficit reduction the UK implemented austerity, which tanked its economy, which in turn made its fiscal situation much worse.

Deficit reduction doesn’t necessarily harm the economy. By delaying deficit reduction until the economy has recovered and relying less on spending cuts and more on tax increases on high-income households (which, unlike spending cuts or middle-class tax cuts, will have a minimal effect on demand), governments can achieve fiscal stability without negatively impacting the economy. But most austerity packages don’t look like that, meaning that most austerity is actually counter-productive. For this reason, the best thing for the deficit might be if we just left it alone and focused on economic growth.

The third reason that the shift towards economic growth makes sense is that it pushes back against this notion that budget policy is just numbers on a page, or simply two lines (spending and revenues) that need to be brought closer together. This view leads to solutions like Paul Ryan’s proposed Medicare reform, which would turn this into a voucher program, saving the government $600 on the typical senior’s health costs but increasing that senior’s out-of-pocket costs by over $6,000. The deficit may be reduced slightly, but the increase in national health costs – and the associated loss of household discretionary income – will be a drag on the economy nonetheless.

Instead, President Obama talked about a different type of debt reduction: public investments. As a nation, we currently under-invest in our transportation, water, and energy infrastructures. The most recent assessment from the American Society of Civil Engineers gave the nation’s infrastructure a “D”, and calculated that we needed to practically double our investments simply to keep the infrastructure in good condition. This under-investment is also a form of debt that we pass onto future generations.

There are two roads that the US can take. The first is the one taken by the UK: cut now and deep, and end up with a stagnating economy and a rising debt. The second road entails greater public investments, which – because they boost the economy in the short run – can help put debt on a sustainable path, and also ensures that we don’t short-change our children and grandchildren by failing to provide them the tools to fuel their own economic growth and prosperity. President Obama chooses the second path, and both he and the country will be better for it.