Austerity FAIL (Romney-style)

by pdxblake

According to a blogger at the American Enterprise Institute, James Pethokoukis, Romney will focus his deficit reduction on cutting government spending without raising taxes, the standard plan for current conservative thinking, and cites an op-ed from Glenn Hubbard, an advisor to Romney saying that: “Hubbard suggests American-style austerity — cutting spending and debt without raising taxes — and the policy certainty it brings can lift growth both in the short and long term.”

This is standard conservative orthodoxy (with a nod to Grover Norquist’s inane pledge binding most Republicans to no new taxes ever).  However, it is nonsense, particularly starting from the position the economy is currently in of a liquidity trap (pdf), where the private sector continues to deleverage.  If the government joins in by cutting spending it will contribute to more slowing in the economy, lower employment, and further need for the private sector to deleverage instead of making investments in new capacity (since overall demand will fall).

As the total spending in the economy falls, GDP will either fall or continue to rise at an anemic rate, doing nothing to lower the deficit as a percentage of GDP.  The ‘wonder’ of the conservative model comes from faulty economic assumptions that ‘certainty’ from government spending cuts will lead to economic growth (something which has almost never happened, particularly in an economy coming out of a deep recession).

There is some acknowledgement by Republicans that cuts to government spending will hurt the economy (but only cuts to the defense budget).

Then there is a problem with the logic of lowering the deficit only through spending cuts when taxes are low as a percentage of GDP, as they are currently.

Source: FRED

The big drop in tax collections occurred in the early 2000s as the tech boom turned into a bust, and the Bush tax cuts were passed (which is why total tax receipts even immediately before the financial crisis were well below the level from the late 1990s).

The claim also that tax rates are high is clearly false as well: the highest marginal tax rate, as well as the tax rate on investment is at its lowest level in decades.

Source: Think Progress

The deficit cannot be entirely closed by undoing the Bush tax cuts, but it will have a big impact.  The Center on Budget and Policy Priorities (CBPP) estimates that allowing the Bush tax cuts to expire would almost cut the deficit in half by 2021.

Source: CBPP

Any plans to cut the deficit should be implemented over many years, so that the spending cuts and tax increases do not derail the current recovery.  These plans will have to include some spending cuts, but cannot be accomplished by cuts alone (and the counter argument about taxes being high is false: tax collections are well below near historical levels).

Right now, the focus should be on stimulating the economy (which will increase GDP, and lower the deficit as a share of the total economy), with some plan for longer-term deficit reduction.  Given the political environment, it makes sense to start with the areas that have the most popular support, as well as those that will have the smallest negative impact on the economy as a whole (rhetoric about “job creators” be damned), which is why the Obama Administration’s plan to let the Bush tax cuts expire at the end of 2010 2012 makes the most sense.

Any plan to cut deficits over the next decade so they are smaller than the long-term growth rate in the economy (2-3%) to make them sustainable over the long-term will have to come from a mix of spending cuts and tax increases, including eliminating large tax cuts on the wealthiest.  Letting the highest end Bush tax cuts expire is a good start until a more comprehensive plan takes shape (with or, more likely, without Republican help).