Workers & Economic Inequality

Budget Deficits Shrinking at the Expense of Economic Recovery

Blog Post by: Andrew Fieldhouse , on February 27, 2014

A refreshing degree of punditry nonchalance greeted the latest release of the Congressional Budget Office’s (CBO) updated budget and economic projections. This had Paul Krugman rightfully rejoicing over the Beltway’s rhetorical U-turn, as “the price for years of warped discourse and completely wrong priorities has been immense.”

Why the change in tune? For starters, all hopes for a bipartisan deficit reduction grand bargain—which had been fueled with deficit fear mongering—have crashed and burned. But much of this newfound fiscal antipathy stems from the federal budget deficit plunging rapidly from a recession-swollen, post-war high.

The GOP’s “trillion dollar deficit” epithet no longer applies. (Not that it ever should have carried any weight.) Bigger budget deficits are desirable during a severe economic slump. And therein lies the problem.

The U.S. economy remains far from healthy, but Congress has prematurely prioritized deficit reduction.

Why is this significant? Government spending acts as a shock absorber for depressed aggregate demand. This needed economic support was withdrawn well before private investment and household spending were capable of making up the sizable demand shortfall from the housing bubble’s collapse.

If you are going to judge the president and Congress solely on deficit reduction, you would have to credit them for an emphatic job. The federal deficit peaked at 9.8 percent of gross domestic product (GDP) in fiscal year 2009. 

Projections by the CBO show the deficit falling to just 3.0 percent of GDP for fiscal year 2014 (which started October 1 this past fall). Deficits have fallen faster over the past three years than any time since the military demobilization following World War II.

But that's beside the point -- we shouldn’t be judging them on deficit reduction. To quote the mantra of an earlier administration, “It’s the economy, stupid.”

Supporting and growing a healthy, vibrant economy can also reduce budget deficits, but with greater benefits for all. That’s what we should be judging them on.

What Makes a Budget Deficit?

To understand how it is that budget deficits rise and fall, let’s look at what contributes to them.

Every economy has a “potential output”—that is, what the economy could sustainably produce based on the supply of productive resources, such as labor, capital, and industrial capacity.

You can think of this as the economy running at full employment in a parallel universe.

As demand falls below this potential, tax revenues fall alongside depressed business activity and household incomes. Similarly, higher rates of poverty, elevated joblessness, and lower income increase eligibility for programs such as food stamps, unemployment insurance, and Medicaid. These cyclical economic effects add to the budget deficit.

For every dollar the economy falls from its potential output, the budget deficit increases by roughly 35 cents. The CBO projects the U.S. economy will run $723 billion below potential output this year, adding $261 billion to the budget deficit.

The remainder of the deficit, resulting from tax and budget policies largely outside the influence of economic performance, is the structural budget deficit—or cyclically adjusted revenue, less spending.  For example, annual appropriations for the discretionary budget, earned Social Security benefits, and Medicare physician payments overwhelmingly fall into this category.

Where Is Our Deficit Shrinking Fastest?

The figure below depicts the budget deficit as a share of GDP, split between the structural budget deficit and the cyclical contribution.


While the contribution to the budget deficit from cyclical factors has fallen 30 percent over the past four years, the structural contribution has plunged by 73 percent. Over this period, the budget deficit fell by a whopping $780 billion—slightly more than the current aggregate demand shortfall below potential output—$668 billion (86 percent) of which has been from the structural component.

So the very rapid decline in the budget deficit is overwhelmingly not a story of a healthier economy bringing in more revenue and automatically reducing safety net spending.

What Went Right, What Went Wrong

Congress has guided this process—both tacitly, by allowing fiscal stimulus policies to expire, and actively, by pursuing deficit reduction policies.

The biggest discretionary fiscal stimulus was the Recovery Act, which reversed the economy's contraction and propelled economic growth in 2009 and 2010. The Recovery Act’s boost peaked mid-2010, increasing GDP by roughly 2.7 percent, but the boost had fallen under 0.2 percent by last year’s end. That’s because the Recovery Act’s stimulus was directly tied to its addition to the budget deficit, which swung from an annual rate of $370 billion in early 2010 to $45 billion in early 2013.

More recently, a payroll tax cut that had been propping up disposable income by about $120 billion for each of the previous two years was allowed to expire at the start of 2013. Emergency unemployment benefits were recklessly allowed to expire this January despite abundant need.

Such deliberately enacted economic supports increase the structural budget deficit, but their economic boost reduces the cyclical deficit by moving the economy back toward potential. The boost from effective stimulus offsets roughly half of the sticker price, which is estimated as only adding to the structural deficit.

And since the GOP retook the House of Representatives in early 2011, Congress has enacted considerable austerity measures—largely the result of Congressional Republicans extorting threats of sovereign default and government shutdowns to extract spending cuts. Austerity reduces the structural deficit at the expense of increasing the cyclical deficit, with about half the structural deficit reduction counterproductively leaking into bigger cyclical deficits.

Adding these policy decisions up, the consequence of austerity and premature withdrawal of stimulus has been self-inflicted economic stagnation.

It Didn’t Have to Be This Way

As it turns out, recovering from a recession is not a new thing; we have done it before.

The figure below from Josh Bivens and Hilary Wething of the Economic Policy Institute shows how inflation-adjusted government expenditure has uncharacteristically flat-lined following the Great Recession.

In economic expansions following post-World War II recessions, inflation-adjusted government spending had increased on average by roughly 15.7 percent in the first four years after each recession’s end. Following the Great Recession, this growth was a meager 1.6 percent.

“Had we tracked this normal [post-recession] historical experience we would have about $800 billion more public spending and the economy would be essentially back to pre-recession health,” Bivens estimates.

A sizable portion of this budgetary anomaly stemmed from deep state and local budget cuts, which had effectively offset the boost from the Recovery Act by 2010. States and localities don’t have the ability to borrow cheaply in global financial markets and many states are legally required to maintain balanced budgets.

But these realities only increased the onus on the federal government to be the spender of last resort, maintaining fiscal stimulus (some of which went directly to shoring up state budgets) instead of adding to the austerity bill.  

Creating Our Own Drag on the Economy

Not long ago, there was a time when policymakers were rightfully screaming to high heaven about the budget deficit falling too quickly—even if they didn’t realize it. This was the “fiscal cliff” of expiring tax cuts and legislated spending cuts scheduled for the beginning of 2013, posed to push the economy back into recession.

Congress mitigated about half that drag and the U.S. economy decelerated markedly in late 2012 and early 2013. But the economy didn’t go over a palpable “cliff” (which was always a terrible metaphor).

Instead, fiscal policy has exerted a subtler headwind of slightly greater magnitude, spread over three years—and preventing growth rates required for escape velocity from economic stagnation.

Over the last three years, inflation-adjusted GDP growth averaged 2.2 percent—roughly enough to maintain the economic status quo and make only slight progress toward recovery. That’s because the economy’s inflation-adjusted potential grows at about the same annual rate (CBO projects 2.1 percent over the next decade), so this is like treading water instead of closing the gap between potential and depressed actual output.

Merely removing the direct drags from falling government investment and expenditure (thus ignoring the expiration of tax and transfer payment stimulus, which show up as consumption in the GDP data), the economy would have instead been growing 2.7 percent. Without austerity and with some sustained fiscal stimulus, escape velocity to a healthier economic cycle would have been realized.

The structural deficit would be bigger, but cyclical deficit would be smaller and the total budget deficit would still have been on a steadily downward, sustainable trajectory.

So thanks to deficit reduction, we no longer have a trillion dollar budget deficit. But how many Americans would be willing to trade back for a trillion dollar budget deficit if it meant full employment?

Tags: u.s. economy, recovery act, great recession, government spending, gdp, fiscal stimulus, fiscal cliff, economy policy, economic stagnation, budget deficit,

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