This Keynesian Votes for Austerity

Battle lines are being drawn over whether America and indeed the world needs to increase government spending in order to stimulate economic growth or institute austerity measures to stem the tide of crippling government debt. 

I am a Keynesian - I believe in government stimulus - but I cannot endorse Keynesian policies at this time because we have failed to adhere to Keynesian theory for so long. Put into the simplest of terms Keynesian economic theory tells us that government should engage in deficit spending during economic downturns in order to compensate for lax private sector activity and to spur economic growth. This can be accomplished via spending, tax cuts, or both. This aspect of Keynesian policy has been standard practice since the 1930s.  Even the Reagan era policies - often derided as supply side or trickle down - were truly Keynesian. The tax cuts were financed via large federal deficits. These government financed tax cuts spurred tremendous economic growth during the 1980s.

But deficit spending only tells half the Keynesian tale. The rest of the theory holds that during times of economic growth, government must pay down the debt incurred to bring about that growth. So once an economy returns to healthy growth deficit spending must be reigned in, debt paid off. This is accomplished via spending cuts, tax increases, or a bit of both. This aspect of Keynesian economic policy has never been standard practice - rather our government (and in fact most western democracies) have instead maintained the "stimulus" policies of deficit spending even during strong economic times.

Look at the chart to the right -  it tracks total US debt as a percentage of the overall economy, or GDP. During our nation's first century you'll notice a rise and fall of our debt to GDP ratio. Our debt was high after the Revolutionary War, but we slowly retired it. It grew again during the War of 1812, but we retired it, it spikes during the Civil War only to fall again.

We see another spike following World War I and a steady decline just prior to the onset of the Great Depression -at which time Keynesian economic policy truly comes to America. Our prior periods of debt were caused by national crisis - War. The debt accrued during the Depression was related to an attempt to mitigate a financial crises. At the onset of the Great Depression our nations accrued debt was only 16.3% of GDP. Depression era deficit spending, or stimulus, doubled our debt ratio to post-World War I levels.

This spending did halt the dramatic economic declines on the early 1930s, but did not produce sustained growth. That would not occur until the build up for World War II when US debt ballooned to a rate more than twice that of GDP. Note in the next chart how economic growth peaked during the height of wartime spending. Though there was a decline in growth after the war, it was short lived and followed by a half century marked by economic expansion and brief episodes of contraction, or recession.

If you return to the first graph you'll see that initially we did begin to retire our debt. The US debt to GDP ratio fell dramatically during the post war economic boom. This halted during the latter part of the 1960s as economic crisis and the Vietnam War put pressure on our economy and the US budget. Our debt to GDP ratio fell to Depression-era levels, but has never since fallen below those level.

The economic expansion of the 1980s and 1990s should have been met with measures intended to retire our burgeoning debt - but those tough decisions were not made - with two exceptions. The Omnibus Budget Reconciliation Act of 1993 increased taxes. It created 36 percent and 39.6 income tax rates for individuals in the top 1.2% of the wage earners, it created a 35 percent income tax rate for corporations, the cap on Medicare taxes was repealed, and transportation fuels taxes were raised by 4.3 cents per gallon. The result was increased federal revenue and declining debt. Then in 1997, the Balanced Budget Act of 1997 trimmed hundreds of billions from the Medicare program - reducing government spending.

The net effect of these two acts was a brief period of surpluses during the late 1990s/early 2000s (see the third graph). But this era was short lived. Congress gave into special interest pressure in 1999 and restored many of the Medicare cuts in the Medicare Balanced Budget Refinement Act of 1999. Returning to the second graph we can see a period of recession in early 2000-2002.

That recession was met with an aggressive tax reduction/stimulus plan - The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). EGTRRA reduced tax rates across the board and reduced the top rate from 39.6% to 35%. In addition, taxpayers were sent rebate checks ranging from $300 a person to $600 a couple to stimulate the economy. Economic growth returned until the current downturn.

Those 2001 tax cuts and the Medicare increases came at a high price as US deficits soared and our debt to GDP ratio began to rise again.

So we find ourselves in 2010 in the midst of a dramatic economic slowdown. Unemployment is at 9.5% and the US economy has lost 8 million jobs in the last two years. In late 2008, Congress passed the Troubled Asset Relief Program or TARP to allow the United States Department of the Treasury to purchase or insure up to $700 Billion of "troubled assets". In January of 2009 Congress passed the American Recovery and Reinvestment Act which appropriated $787 billion in tax cuts and spending. TARP and the Recovery Act were financed via deficit spending and added greatly to our debt and deficit.

Total US debt has reached 80% of GDP and is expected to surpass GDP by 2015. We are already at levels not seen since the height of World War II.  The most recent economic outlook from the Congressional Budget Office looks at the share of debt held by the public, as opposed to what the government owes itself, finds that debt to GDP ratio is 62%, but "federal debt held by the public would rise... to 181 percent of GDP in 2035, and annual deficits would exceed 10 percent of GDP beginning in 2027." 

Why does this matter?

If the ratio of debt to GDP continues to rise, lenders may become concerned about the financial solvency of the government and demand higher interest rates to compensate for the increasing riskiness of holding government debt. Eventually, if the debt-to-GDP ratio keeps increasing and the budget outlook does not improve, both foreign and domestic lenders may not provide enough funds for the government to meet its obligations. By then, whether the government resolves the fiscal crisis by printing money, raising taxes, cutting spending, or going into default, economic growth will be seriously disrupted.

So how does all of this come back to my current opposition to additional stimulus and more Keynesian demand side policies? Simple, we have defied Keynesian policy for over 40 years. Since the late 1960s we have continually spent beyond our means in good times and lean years. Rather than pay down the debt accrued during periods of recession, we have continued to accrue debt at an alarming rate. At the onset of the Great Depression our debt to GDP ratio was but 16% and our budget balanced. Today, we entered the Great Recession with a debt to GDP ratio of 80% and a budget habitually out of balance. Rather than stimulus, America must embrace austerity. Such austerity will cause pain, but it will be a temporary pain as we pay for the excesses of the past 4 decades. The other option is continued deficit spending and crushing debt that we will never be able to grow out from under. The choice is between short term pain with long term health (austerity) and short term relief with long term ruin (stimulus).