It's the Austerity, Stupid: How We Were Sold an Economy-Killing Lie
Once again, the Beltway fell for cherry-picked data—and you paid the price.
It was the Excel error heard round the world.
In January 2010, as the global economy was slowly beginning to claw its way out of the depths of the Great Recession, the Harvard economists Carmen Reinhart and Ken Rogoff published a short paper with a grim message: Too much debt kills economic growth. They had compiled a comprehensive database of debt episodes throughout the 20th century, and their data told an unmistakable story: Time and again, countries that rack up high debt levels have gone on to suffer years—sometimes decades—of stagnation.
As economics studies go, it was nothing short of a bombshell. As its conclusions were invoked from Washington to Brussels, tackling the recession suddenly became less important than tackling deficits. For the next three years, stimulus was out, austerity was in, and the protests of critics were all but buried amid the headlong rush to slash spending.
But then, on April 15 of this year, a trio of researchers at the University of Massachusetts published a paper that took a fresh look at Reinhart and Rogoff's study. It turned out there was a problem: R&R had presented data from a list of 20 countries that filled lines 30 through 49 on a spreadsheet. But the formula that calculated the results relied on lines 30 through 44. Oops.
On its own, the spreadsheet error had only a modest effect on the paper's conclusions, but the UMass team had other, weightier criticisms that taken together called R&R's conclusions into serious question. Still, under ordinary circumstances the whole thing would have been little more than a dry academic debate.
But these were far from ordinary circumstances. Like a well-aimed snowball that sets off an avalanche, the UMass paper changed everything.
To fully understand the R&R affair, let's return to that moment in January 2010. Technically, the Great Recession had ended several months earlier. But the economic reality of working Americans remained bleak. The unemployment rate continued to hover near 10 percent. A broader measure that includes discouraged job seekers and those forced to accept part-time work was near 17 percent. GDP was growing again after a disastrous 2009, but at an anemic rate of about 2 percent a year. Wage growth, adjusted for inflation, was actually negative: Salaries were shrinking, and still no one was getting work.
The problem, from an economist's perspective, was a simple one: The housing bubble had burst, and banks were stuck with enormous losses on their housing-related securities. They desperately needed to sell assets to remain solvent, but when everyone wants to sell all at once, and nobody wants to buy, the result is a death spiral: Falling prices require ever more asset sales, which in turn produce ever steeper price drops and further asset sales. This vicious cycle eventually transformed an ordinary recession into something far more threatening—a banking crisis recession.
Ironically, it was none other than Reinhart and Rogoff who had warned us of this in their magisterial—and sardonically titled—study of financial crises throughout history, This Time Is Different. They found that while government action might rescue broken financial systems fairly quickly (in this latest case via bank bailouts and emergency cash injections by the Federal Reserve), the wider recessions brought on by financial crises typically last a very long time. Five years is hardly unusual.
This wasn't a counsel of despair. If anything, This Time Is Different should have been taken as a well-timed warning to respond to this recession even more forcefully than usual. What was needed was for the federal government to apply the same urgency to rescuing the economy that it had to rescuing the banks.
No Stimulus For You
In every recent recession, rising government spending provided a backstop to the recovery except this one.
Our general economic problem, after all, was similar to the banking system's. Everyone suddenly needed to pay down all that debt they had taken on so exuberantly during the bubble. In other words, everyone wanted to save, and no one wanted to borrow or spend. This is a recipe for deep and long-lasting disaster, famously described by John Maynard Keynes as the paradox of thrift: Although it's normally a virtue for individuals to save money, it brings the economy to a grinding halt when everyone stops spending at once. Factories are shuttered, workers are laid off, and unemployment skyrockets. The only way to avoid the worst is if someone steps in with massive amounts of spending to keep the economy afloat until everyone's bills are paid down and normal life resumes.
The federal government is the only logical candidate for this rescue operation, and with recovery still perilously weak in 2010, the obvious response would have been a second dose of stimulus spending. But the political world was already moving in the opposite direction. Republicans had voted against President Obama's first stimulus bill almost unanimously, and there was little reason to think they'd be any more receptive to a second round. Nor was it just Republicans. By the fall of 2009, with the economy still on life support, the Wall Street Journal was already reporting that there was internal disagreement within the White House about whether to push for more stimulus or to begin a pivot toward addressing the country's mounting deficits. In the end, for reasons both political and ideological, Obama decided that he needed to demonstrate that he took the deficit seriously, and in his 2010 State of the Union address he did just that. "Families across the country are tightening their belts," he said, and the federal government should do the same. To that end, he announced a three-year spending freeze and the formation of a bipartisan committee to address the long-term deficit.
The Beltway establishment may have applauded Obama's pivot to the deficit, but much of the economic community saw it as nothing short of a debacle. Sure, there were still a few economists who believed that even in a deep recession government spending merely crowded out private spending and thus did no good, but they were a distinct minority. Most economists acknowledged that deficit spending was appropriate at a time like this. Paul Krugman fumed that Obama was cravenly trying to score political points by doing a "deficit peacock-strut" that would be destructive in the wake of the financial crisis. Mark Zandi, a centrist economist who has advised leaders of both parties, used more judicious language, but likewise warned that spending cuts might "cost the economy significantly in the longer run."
Triumph of the Deficit Hawks
Annual federal spending deficit (in billions)
It was at this point, with the political world still wavering between stimulus and austerity, that Reinhart and Rogoff waded in with their explosive paper, "Growth in a Time of Debt." It was couched in the usual sober language of academic economists, but its takeaway was simple: Contrary to conventional economic wisdom—but in keeping with the arguments of tea party Republicans and austerity enthusiasts worldwide—deficit spending actually might hurt rather than help economies recovering from a recession. After an exhaustive review of government debt levels throughout history, they concluded that there was a hard threshold beyond which government debt got so high, it could actually tank the economy. When debt was between 0 and 90 percent of GDP, there was no problem. But when debt exceeded 90 percent of GDP, economic growth was cut in half.
Their paper couldn't have been timelier if it had been issued as a traffic alert during rush hour. The month it was published, US debt—fueled by two years of recession-starved tax receipts, increased outlays on the unemployed, and an $800 billion stimulus bill—ticked over from 89 percent to 91 percent. Obviously, we were doomed.
The R&R paper, Krugman said, "may have had more immediate influence on public debate than any previous paper in the history of economics." It's not that they were the first economists ever to warn of the dangers of deficit spending. There had always been plenty of those. But Reinhart and Rogoff really seemed to deliver the goods. It was no longer a matter of whether deficit spending was helpful in principle—an argument that had been going on for decades and showed little prospect of ever being resolved. Even if it was, they seemed to say, it just didn't matter. In this particular recession, we were already past the 90 percent danger point where further debt would have disastrous future consequences.
And with that, the trajectory of the next three years was set: It would be austerity as far as the eye could see. Reinhart and Rogoff's conclusions were featured in newspapers around the world. They were cited by columnists. They testified before Congress. The head of the European Union's commission on economic policy used their findings to justify sharp spending cuts designed to reduce government debt in Greece, Italy, and Spain.
American deficit hawks were singing the same song. Future VP nominee Paul Ryan warned that a debt level above 90 percent "intensifies the risk of a debt-fueled economic crisis." Republicans eagerly jumped on the Ryan bandwagon, and frightened Democrats went along. "We're past the danger zone," Sen. Kent Conrad (D-N.D.), head of the Senate Budget Committee, said at the time.
The result was predictable: spending cuts and more spending cuts. First came budget deals in 2010 and 2011 that reduced the deficit by $760 billion. Then, in August 2011, Obama struck an agreement with Republicans to resolve the debt ceiling crisis, which produced about $1.1 trillion in spending cuts along with the promise of more from a congressional supercommittee. At the end of 2012, the fiscal-cliff showdown resulted in $850 billion in tax increases and spending cuts. Finally, in March, sequestration cuts (cued up when the supercommittee failed to produce a deal) kicked in, to the tune of another $1.2 trillion. Taken as a whole, these measures have cut the deficit by $3.9 trillion over the next 10 years. And that doesn't even count the expiration of desperately needed stimulus measures like the payroll tax holiday and extended unemployment benefits.
This was unprecedented, as the chart above shows. After every other recent recession, government spending has continued rising steadily throughout the recovery, providing a backstop that prevented the economy from sliding backward. It happened under Ronald Reagan after the recession of 1981, under George H.W. Bush after the recession of 1990, and under George W. Bush after the recession of 2001. But this time, even though the 2008 recession was deeper than any of those previous ones, it didn't.
Because most state budgets are required by law to be balanced, it's normally the job of the federal government to keep spending on an upward path during a recovery. But with federal outlays squeezed by all the budget deals, total government spending peaked in the second quarter of 2010 and then started falling, falling, and falling some more. Today, government spending at all levels—state, local, and federal combined—has declined 7 percent since the publication of Reinhart and Rogoff's paper.