From 2009 to 2012, the US federal deficit shrank from 10.1% of GDP to 7% of GDP.  That’s the fastest deficit reduction we’ve seen in six decades—and all before the fiscal cliff has kicked in.  Here’s the chart from Jed Graham:

Put this alongside a record-setting contraction of government employment and a 7.9 percent unemployment rate, and what you have is a portrait of fiscal irresponsibility.  A lot of this deficit reduction has to do with the fact that the economy is now growing (albeit feebly), instead of contracting, but looking at this chart should also reinforce how dangerous and unnecessary it is that we’ve decided to create an austerity crisis at this moment.  (This “austerity crisis,” by the way, should really be understood to include both the possibility of going over, and staying over, the fiscal cliff AND the possibility of the cliff being replaced by a “grand bargain” on deficit reduction.)  The last time the deficit was reduced at a faster rate was in 1937, when the government embraced a hard pivot to austerity and the economy tumbled back into recession.

But don’t worry, we aren’t reliving the history of the 1930s.  Not exactly.  We are combining fiscal irresponsibility with regulatory negligence.  The Financial Stability Board (FSB) reported on Sunday that the shadow banking sector, after contracting in 2008, has rebounded nicely and is doing just fine.  Although it hasn’t quite seen the growth it did prior to the crisis, when it doubled in size from 2002 to 2007 (from $26 trillion to $62 trillion), the shadow banking sector reached $67 trillion globally in 2011—a new record, and “equivalent,” says the FSB, “to 111% of the aggregated GDP of all jurisdictions.”

Amity Shlaes, whose main claim to fame is an allegedly new history of the Great Depression, thinks we may be in trouble as a result of the election. Looking beyond her alarmingly alliterative title (“2013 Looks to be a Lot Like 1937 in Four Fearsome Ways!”  Oooh! Scary!) she has some valid points. Of course she is talking about the stock market not the real economy, which produces the jobs and the economic benefits most people rely on for a living. And, unfortunately, she doesn’t realize where she is right.

But first, what are the four fearsome factors that will drive us to doom? First, a federal spending spree before the election. Shlaes uses “the old 19% rule” as a benchmark to argue that because federal government spending in 2012 “when the crisis was long past” was 24.3% of GDP, clearly the Obama administration was spending up a storm. To argue that the crisis is long past, one must be willing to ignore the employment crisis that still hasn’t left us, but let’s give her this one. Whether this is a problem given current economic conditions is another story. If it’s the debt implications you’re worried about, it is worth noting that revenues as a percentage of GDP are also quite low historically speaking, just over 15% for the last few years (see CBO’s historical budget data).

Shlaes’ second fear factor is a bath of cold water afterwards. Roosevelt restored budget balance in 1937 and since that very topic (and who David Petraeus was or was not sleeping with) is all people are talking about in Washington these days it seems likely we’ll get spending cuts and tax increases in the next budget. The “depression within the Depression” was the result of exactly this fiscal restraint. This is where Shlaes is quite right, though she doesn’t actually come out and say this: whether the President and Congress jump off the fiscal cliff together, which would reduce spending across the board, or avoid it by cutting spending on everything but defense instead, we are in for poor economic performance indeed.

Shlaes’ third scary thing is the fearsome attack on the status quo. In 1937, this meant raising the top marginal rate from 56% (where it had been raised by Hoover in 1932 from 25%) to 62% (this actually passed in 1936) and the undistributed profits tax. This, and Roosevelt’s attempts to pack the Supreme Court meant that (stock) markets “shivered.” Note that this year, Obama is talking about raising the top rate to, um, 39.6%, which is where it was before the Bush tax cuts. Remember how much markets were “shivering” in the 1990s? Me neither.

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The fiscal cliff is very easy to explain.  What many in Congress and the press are saying we should do about it is more confounding.

If you were the sort of person who took expressions of policy preferences at face value, you would think that fiscal conservatives and deficit hawks would be ecstatic about this thing we’re calling the “fiscal cliff”—because contrary to our increasingly muddled popular dialogue, the fiscal event about which everyone is raising alarms is just a large and rapid reduction of the budget deficit (about $600 billion of spending cuts and tax increases scheduled for 2013).  Given the widespread deficit hysteria we’ve witnessed over the last few years, it is likely confusing to a lot of unsuspecting observers that so many in Washington and the mainstream press are dead set against this particular piece of deficit reduction.

The American public has been ill-prepared for this consensus.  We’ve been told, ad nauseum, that fiscal “stimulus” didn’t and doesn’t work.  But the case for fiscal stimulus is simply the flip side of a case against austerity that few seem to realize (or are willing to recognize) that they are making. continue reading…

As Dimitri Papadimitriou recently observed, the overwhelming push for austerity in the United States is partly driven by the sense that deficit reduction simply cannot wait:

Many in Washington and the media are convinced that the recovery is well underway, and if spending cuts and tax increases are delayed for even a year it will be too late to tame inflation and tighten fiscal policy on a soaring economy. The urgency rests on unfounded optimism. We still have a very long way to go before the economy is anywhere near healthy enough to heat up. The GDP is now, and has long been, far below trend.

Here’s how Papadimitriou and Greg Hannsgen illustrate the point in a recent policy brief:

It is rather odd to be concerned about deficit reduction coming “too late” (i.e. that the black line will rise above the pink line), given how far we are from the historical growth trend.  As Papadimitriou and Hannsgen put it:  “Based on the present state of the economy, any notion that implementing better policy would be mostly a matter of precise timing is patently absurd.  The gap between recent real GDP growth and the historical trend is so large that the danger of overshooting the trend is hard to imagine.”*

Many proposals in this budget battle, including some coming from alleged “deficit doves,” call for replacing the fiscal cliff (over $500 billion in deficit reduction in 2013 alone) with what is essentially a different austerity package spread out over a longer time frame (the consensus target seems to be about $4 trillion of deficit reduction over ten years), otherwise referred to as a “grand bargain” in the media.  But notice that even if we continue on our current austerity-lite path (that is to say, without the fiscal cliff and without a grand bargain), and we continue to add jobs at roughly the same rate we’ve been adding them lately, we likely won’t be back to full employment for ten years. continue reading…

Last month, numbers from the Bureau of Labor Statistics suggested that the years-long decline in public employment had finally halted, but Friday’s BLS report revealed that we moved back into negative territory in October:  the public sector as a whole (federal, state, and local) shrank by 13,000 jobs.  This should serve as another reminder that a significant part of this jobs crisis is self-inflicted.  There is a lot of policy work that needs to be done to help bring the economy back to full employment, but one of the baby steps the government can take in dealing with the crisis is this:  stop firing so many people.

Here’s Floyd Norris back in August, writing about a fact that has received far too little attention in our civic dialogue:

Employment in state and local government peaked at a seasonally adjusted 19.8 million workers in August 2008. Since then, the total is down by 697,000, or 3.5 percent. Since World War II, the only comparable decline was in 1950 and 1951, when payrolls fell by 3.7 percent.

The recession left state and local governments, where most government jobs are located, in a very real budget bind, leading to a rate of layoffs unprecedented in over half a century.  While the federal government also saw its revenues drop precipitously when the recession hit, unlike states and municipalities, it is currently under no economic constraint to balance its budget. The Recovery Act (ARRA) provided some aid to states and municipalities to help cover their budget shortfalls, but it was clearly insufficient, and now that the American Jobs Act (which featured further aid to states) has disappeared from the public radar there is little reason to believe that more help is on the horizon.  In fact, despite all the fiscal space the federal government has at its disposal, a large(r) dose of federal austerity is scheduled for 2013 that will do even more damage to public payrolls (here’s one estimate of the damage from the Congressional Research Service).

To put public job creation or preservation back on the policy radar, to begin forming a public consensus around rebuilding the public sector workforce (or just halting its demolition), there has to be some widespread acceptance of the fact that government has, in this particular sense, shrunk—and shrunk significantly—over the last four years.  From a purely rhetorical standpoint, the case for direct job creation, or aid to states for direct job preservation, should be a relatively straightforward argument to present to the public (compared to, say, something like quantitative easing).  But the task is made much more difficult if we’re making the arguments in a context in which everyone knows that government has become bloated during President Obama’s time in office. continue reading…

Many of the themes in fiscal policy, economic growth, and distribution that we have been working on here have been in the news lately. Scholars from many fields are weighing in. One common theme is dynamics and their importance:

1)      Evidence of a self-reinforcing fiscal trap in operation in Britain, forwarded by the NIESR, a British think tank:  Dawn Holland and Jonathan Portes argue today in Vox that in the UK austerity has led to higher debt-to-GDP ratios, defying the predictions of orthodox macro models. For something from our Institute on the topic of fiscal traps, including the UK example, you might take a look at this public policy brief from Dimitri Papadimtriou and me, posted just last week.

It is important to keep in mind, as the authors of the British study point out, that fiscal austerity is hardly the only cause of the economic crises now underway in much of the world. For example, they get at the problem of coordinating macro policies in a group of open economies. Above this paragraph is a diagram from our brief, illustrating, among other things, the role of Minskyan financial fragility in generating crises in many places in the world. This role is shown by the light green arrows in the diagram, which show how rising numbers of “Ponzi units,” (firms and households that need to borrow in order to make their interest payments) can play a role in a fiscal trap. Spending cuts or tax increases are sometimes “self-defeating” in this view because they undermine the tax base—the amount of activity subject to taxation. The mechanism involved is a Keynesian multiplier effect. Internationally, there are many examples of this problem these days.

2)      More on models of economic growth and income distribution and their relationship to models from applied mathematics in letters to the editor of the Financial Times (here and here) and in a blog post from a mathematician: The FT letters discuss, among other things, the perhaps debatable role of unemployment in keeping real wages from rising. On the other hand, the blog post discusses various kinds of discontinuous dynamic behavior that fall under the rubric of catastrophe theory, mentioning a classic business-cycle model by Nicholas Kaldor and various sorts of straws that break camels’ backs. Author Steven Strogatz notes that “in some…cases (boiling water, optical patterns), the picture from catastrophe theory agrees rigorously with observation. But when applied to economics, sleep, ecology, or sociology, its more like the camel story—a stylized scenario that shouldn’t be taken for more than it is: a speculation, a hint of something deeper, a glimpse into the darkness.”

All of these ideas play a role in numerous macroeconomic models, including the one that I discussed in this post, which features CDF interactive graphics. New macro team hire Michalis Nikiforos has been working on many of these issues, too.

This old post on the question of how to make sense of the claim that government debt places a net “burden” on future generations—the question of whether there’s an economic case to be made that supports the common claim that today’s public debt levels are an immoral burden on our children and grandchildren—generated a fair amount of discussion here.  The issue has been revived again in a recent back-and-forth that some of our readers might find interesting.  The latest round began with a post by Dean Baker, who said this:

A moment’s reflection shows why the debt is not a measure of inter-generational equity. At some point everyone alive today will be dead. At that point, the bonds that comprise the debt will be held entirely by our children or grandchildren. The debt will be an asset for the members of future generations that hold these bonds. This can raise distributional issues within a generation. For example, if Bill Gates’ grandchildren own the entire U.S. debt there will be important within generation distributional consequences, however this says nothing about inter-generational distribution. …

As a generational matter, we pass a whole economy, society and environment to our children. Unless we have given them a really bad education, they would be crazy to opt for a government with a lower national debt in exchange for a weaker economy, a worse infrastructure or more damaged environment.

Nick Rowe took exception, kicking off the discussion here.  Brad DeLong responded to Rowe here; Mark Thoma responded here; and Baker responded here and here. Paul Krugman also weighed in, and then addressed the particular issue of foreign ownership of debt.

We expect the unexpected at the Levy Institute. As followers of Keynes, most economists here, including this author, believe that one cannot assign exact probabilities to most important economic outcomes even, say, six months into the future.

On the other hand, thinking about the economic debate on job creation, and the recent release of new jobs data, I have not been very surprised at the gradual pace of progress in reducing the unemployment rate. In fact, we on the macro team have consistently called for more fiscal stimulus rather than less. The reason is that unemployment is a relatively slow-moving variable. As the chart at the top of this post shows, the unemployment rate (shown as a blue line) fell only rather gradually after each of the previous three recessions (shown as shaded areas in the figure). (Here, we count the double-dip recessions of 1980 and 1981–82 as one.) Hence, once the recovery began, we knew that with the unemployment rate at very high levels, it needed to fall unusually fast to be at reasonable levels by this point in the Obama administration.  Hence, since 2007, the team has advocated an easing of fiscal policy. Instead, especially after the 2009 ARRA, little action was taken by the government to stimulate the economy. Partly as a result of inaction on fiscal stimulus, government employment as a percentage of the civilian workforce (red line in the figure above) peters out after 2010.

At this point, we hope for legislation to moderate January’s expected “fiscal cliff”—which will lead to perhaps a $500 billion in reductions in the federal deficit in 2013 unless laws are changed, by CBO estimates.  (In its current form, the cliff would probably have a serious impact on all economic and demographic groups. Lately, I’ve been working on a model that incorporates the larger effects of an additional dollar of income on spending at lower income levels—not a simple task.)

In the figure, both lines are shown in the same units, namely percentages of the civilian labor force age 16 and above, though the two lines use different scales, one on each side of the figure.  For example, a one-unit change in the blue line represents the same number of workers as a move of one unit in the red line. A hypothetical jobs program or another spending measure that gradually increased government employment (red line) by, say, 1 percent of the total US workforce might easily have led to an unemployment rate (blue line) for last month of 1 to 3 percent less than the actual reported amount. But government does not seem to be expanding; in fact, the red line shows that government employment shrank at a time when more hiring from that sector would have been of great help to the economy. (The figures include employees of local and state governments, as well as those of the federal government. The smaller governmental units have seen the biggest cuts in payrolls.) continue reading…

Whatever the outcome of efforts to resolve severe economic difficulties in Europe and elsewhere, it is becoming increasingly clear that the next big economic crisis may not hinge on interest rates at all. One reason is that the world’s central banks, many of them following something like a Robinsonian “cheap money policy,” have managed to keep interest rates reasonably low in many countries. For example, it seems clear that yields on Spanish and Italian bonds are under control for now, after statements last month by Mario Draghi, the president of the ECB, that he was “ready to do whatever it takes,” to keep interest rates down. As made clear in this interesting and enlightening 2003 book edited by Bell and Nell (Stephanie Bell Kelton and Edward Nell), the theoretical argument for the Eurozone was badly flawed from the beginning.  (Indeed, many in the world of heterodox economics saw these  flaws from the beginning.) But, returning in this post to a key theme in Joan Robinson’s writings on the interest rate, I will offer some of the thoughts of John Maynard Keynes himself, who wrote in 1945 that:

The monetary authorities can have any rate of interest they like.… They can make both the short and long-term [rate] whatever they like, or rather whatever they feel to be right. … Historically the authorities have always determined the rate at their own sweet will and have been influenced almost entirely by balance of trade reasons [Collected Writings*, xxvii, 390–92, quoted from L.–P. Rochon, Credit, Money and Production, page 163 (publisher book link)].

Here in the United States, the Fed has shown its ability as a liquidity provider to keep interest rates on relatively safe investments very low across the maturity spectrum, despite spending much more than it received in tax payments in calendar years 2009–2011, and presumably the current year.  Keynes’s statement, much like the quote from Robinson mentioned above and the one in this earlier post, foretells this outcome.

Hence, recent US experience supports the view that calls for cuts in government spending and/or tax increases cannot be justified by fears that high deficits cause high interest rates at the national or global level.

* Note: The complete set of Keynes’s  works is out of print in hardback and will be reissued as a 30-volume set of paperbacks later this fall, according the Cambridge University Press website. – G.H., September 3

For those who worry that elevated federal deficits and quantitative easing (QE) by the Fed will lead to high inflation, a word about the macroeconomics of the 1970s. The topic came up in the news recently with the passing of economist and former presidential adviser Paul McCracken. In keeping with many orthodox accounts of the era, an obituary in the New York Times cast much of the blame for the stagflation [slow growth combined with high inflation] of the 1970s on “Keynesian” macro policies, in particular large budget deficits:

A wide-ranging thinker, Mr. McCracken was part of a postwar generation of economists who believed that government should play an active role in moderating business cycles, balancing inflation and unemployment, and helping the disadvantaged.

His nearly three years at the White House coincided with a turbulent era marked by rising deficits, rampant inflation, the imposition of wage and price controls, and the breakdown of the system of fixed exchange rates that had governed the world’s currencies since World War II.

As a result, by the early 1980s, Mr. McCracken, like other economists, questioned the Keynesian assumptions that had been dominant since the war. He concluded that high inflation had resulted from “a cumulative paralysis in our will” and called for greater fiscal discipline to limit the growth of government spending — a topic that continues to vex Washington….

Working for Nixon, Mr. McCracken was confronted with an inflation rate that had been rising since 1965, a byproduct of the deficits that the federal government had amassed during the Vietnam War…..

The article paints a picture in which McCracken stood in the middle ground between Keynesian “fine-tuners” of macro policy on the one hand and opponents of “activist” policies, such as Milton Friedman, on the other, who blamed inflation on excessive government spending and erratic growth in the money supply.

The view represented by the Times article is far from the only reasonable account of the causes of the stagflation of the 1970s, in particular the episodes during which the US experienced double-digit inflation (see figure below, in which year-over-year CPI inflation is shown in blue). continue reading…