Stimulus vs. Austerity: USA

by Benjamin Studebaker

I keep seeing a certain political sentiment expressed. It goes a little something like this, from James Pethokoukis of the New York Post:

So what’s the problem with the Obama recovery? Why is it the weakest since the Great Depression?

Maybe it’s the Obama policies, like a stunning disregard for the trillion-dollar deficits that are likely already a dead weight on growth. Or maybe it’s the Obama guarantee of more tax hikes and regulation that makes US business too worried to hire and invest.

But it’s not too late to start shrinking unproductive government, cut debt and reduce penalties on work and investment — just like in those recoveries that we used to know.

Then there are the political cartoons, things like this:

Here’s the structure of the idea:

  • The economic recovery has been insufficiently strong
  • Therefore, we should do the opposite of what Obama has done
  • Ergo, vote Romney/Ryan 2012

The first point is correct, the other two points are simplistic and anti-intellectual, and I intend to illustrate both how and why.

First let’s briefly explain what the theory is behind stimulus. During a recession, people reduce their expenditure. However, because everyone’s income is the result of everyone’s spending, it is impossible for everyone to reduce spending at the same time without reducing income. The result is a loss in income for businesses, who then lay people off to make up the difference, reducing the output of the businesses as well as causing the laid off workers to spend less money, further reducing business sales, resulting in further unemployment, and so on, in a destructive cycle. Stimulus is meant to intervene in this cycle by increasing the sales to businesses, allowing them to avoid laying off more workers and rehire those that have been laid off. Eventually, when the reason that businesses, consumers, and investors were trying to simultaneously save money is resolved, the private sector resumes normal expenditure, and the government can taper off the stimulus, then take advantage of the resulting boom by recouping its losses in higher tax rates, simultaneously helping to stabilise the boom and prevent it from running out of control. In this case, the reason for the simultaneous saving is high household debt. As families are paying down their high levels of debt, they are spending less money, reducing sales for businesses and resulting in weak employment. To solve this problem, the Obama administration rightly proposed stimulus.

But then something curious happened–the economy has remained weak, and it is partially Obama’s fault that it remains weak. The egregiously off-base assumption made at this point is that because it remains weak, policies that Obama has advocated, like stimulus, have been proven ineffective, and that the opposite of spending–cutting spending, or austerity–must be better, so that the public sector joins the private sector in trying to pay down debts all at the same time.

Don’t misunderstand me here–the stimulus package did undoubtedly fail. However, there are two potential reasons for its failure:

  • Stimulus is the wrong policy; we should cut spending
  • The stimulus was too small; we need more stimulus

The right wants to believe the former because it is ideologically comfortable and consequently refuses to consider the latter. There is, however, absolutely no evidence for the former (when layoffs are caused by a lack of consumer the demand, the last thing the government should do is join those consumers in reducing its own demand–it’s the economic equivalent of harakiri, particularly when you don’t actually have a debt problem) and substantial evidence for the latter, evidence that was available at the time the Obama administration passed the stimulus and which it made the mistake of failing to abide by. The economic recovery is weak because Obama made the error of enacting a stimulus package that was far too small to have any chance of bringing about a robust recovery. Where’s the evidence? Right here:

What you’re looking at here is the “Output Gap”–the difference between the economy’s potential economic output, and how much it has actually generated. Before the stimulus was signed into law, we could see that there was an output gap of $2 trillion. That means that $2 trillion worth of demand needed to made up by the state to bring about a robust recovery in accordance with Keynesian theory. Anything less would not do the full job.

What did Obama pass? A stimulus package of $831 billion, which sounds big but was nonetheless dwarfed by the size of the output gap. It is unequivocally Obama’s fault that the administration did not pursue a large enough stimulus package.  However, Romney and his fellow Republicans not only opposed what little stimulus was offered, they from the start agitated against any stimulus at all and proposed spending cuts instead, cuts that would have resulted in lower total demand, lower incomes for businesses, and higher unemployment.

Did the Obama administration make the case for more stimulus? Not effectively. It instead engaged the Republicans about debt reduction and has proposed spending reductions. The Obama administration has demonstrated a total lack of competence in formulating correct economic policy and making the case publicly for it, but the Republicans are proposing policies that not only will not help the economy, but will in fact hinder it greatly.

It is as if America is a man standing on the threshold of a burning building, advised by two entities, Obama and Romney. Obama advises the man to stay right where he is and not move a muscle, ludicrous advice, and deeply flawed. However, instead of telling the man to flee the building before it collapses and kills him, Romney advises the man to go back into the building, an even crazier and more dangerous policy.

It is as if America is a schoolboy trying to learn algebra, and Obama is a tutor who doesn’t know how algebra works and isn’t particularly useful, but Romney is a tutor who denies that algebra exists and advises the boy to play truant.

In other words, knowing that Obama has failed is not the same thing as knowing that the alternative is better. Just because we have two political parties with two different positions in the United States, doesn’t mean that either of them have the correct answer. You cannot infer “Republicans right” from “Democrats wrong” and vice versa. To do so on issues as important as the economy, the livelihoods of millions of people, is extremely irresponsible and intellectually lazy. All those supporting Romney/Ryan 2012 for economic reasons are guilty of both.

Source List:

New York Post full piece:

Output Gap Chart:

Krugman before the stimulus took effect predicting correctly its inadequacy: