The rush to fiscal austerity began in earnest by April 2011. A “Keynesian moment” in policymaking had emerged in January 2008 when policymakers debated, constructed, and passed a $150 billion tax-cut stimulus package in a single month, purely based on fears that the unemployment rate might breach 6 percent. But that moment passed quickly. By December 2010, the Obama administration had already acquiesced to an agreement extending the Bush tax cuts for the highest tax brackets (for two years) in exchange for some additional fiscal stimulus.

Just three months later, by the beginning of April 2011, roughly a third of the new fiscal support negotiated in December had been erased by nearly $40 billion in cuts to spending over the remainder of fiscal year 2011. The extended tax cuts for the well-off, needless to say, survived the policy whipsaw that was allegedly driven by the need to reduce the size of the federal budget deficit.

Absent a truly radical break with the current trajectory, the question regarding fiscal austerity for the foreseeable future is simply “how much?” In short, we are about to witness a great experiment—the imposition of fiscal austerity in an economy already characterized by extraordinarily high unemployment. We should think hard about how we developed a politics that led us down this hugely damaging path and what its consequences are likely to be in the next two to three years.

How Keynesianism Came and Went in Three Years

It’s easy enough to explain why fiscal Keynesianism—that is, using increased government debt to finance spending projects, transfers to people and state and local governments, and tax cuts in an effort to fight an economic downturn—came into sudden vogue at the beginning of 2008. Private spending—driven by the collapse of an $8 trillion bubble in home prices—simply collapsed, falling by roughly 8 percent of GDP. This shock to private spending was bigger than the shock that led to the Great Depression. What kept a second Depression from happening was largely the fact that today’s much-larger public sector contains built-in shock absorbers (“automatic stabilizers”) that allow tax collections to fall and safety-net spending to rise as the economy falters.

These automatic stabilizers, however, were clearly not sufficient to stop a terrifying downturn—job losses averaged over seven hundred thousand per month for the worst seven months. Given this, it is not hard to see why policymakers were willing to reach deep into the tool kit and grasp something—large discretionary increases in the budget deficit—that hadn’t been used in quite some time. What’s harder to explain is the abandonment of a Keynesian response to the Great Recession, even as unemployment hovers around 9 percent—what would have been its highest level in a generation before the Great Recession hit, and fully 50 percent higher than the merely threatened rates that mobilized Congress into quick action just a couple of years earlier in 2008.

The Strange Ambivalence About the American Recovery and Reinvestment Act

There was obviously much about the official response to the Great Recession that was politically polarizing. In particular, the bailouts of the auto sector and (much more so) the extraordinary efforts undertaken by the Federal Reserve and the Bush administration to save the largest financial institutions—especially the Troubled Asset Relief Program (TARP)—were highly controversial.

However, the signature economic initiative of the Obama administration—the American Recovery and Reinvestment Act (ARRA)—seems like it should have been much more broadly popular. The ARRA provided roughly $800 billion to finance tax cuts to households and corporations, transfer payments to households (like unemployment insurance benefits and food stamps) as well as to state governments (to spend on education and Medicaid payments), and direct spending for infrastructure investments. The architects of the ARRA probably (reasonably) assumed that the balanced portfolio of its spending (roughly one-third of the first two years’ spending went to tax cuts, transfers, and infrastructure projects, respectively) would make it relatively non-controversial.

But they were wrong. The public seems mostly ambivalent about the success of the ARRA, paradoxically liking its constituent parts much more than their sum. Even more puzzling, this ambivalence is not shared by professional economic forecasters, private or public. For this group—whose salary depends on knowing what moves the economic dial in the short term—there is near-unanimity that national income is several hundred billions of dollars higher and there were millions of more jobs in the economy at the end of 2010 than what would have prevailed absent the ARRA.

Unfortunately, public perception defied professional opinion, arguably because the Act—while historically large in terms of other episodes of discretionary fiscal support—was still far too small to neutralize the shock to private sector spending inflicted by the burst housing bubble. Because it was too small, the unemployment rate continued to rise (and quickly) even after the ARRA was passed and (probably even more importantly) remained elevated eighteen months after its passage. Given this, it became hard, indeed, to convince the public that the ARRA had really helped.

This ambivalence about the ARRA has led to insufficient public support—even among many traditionally liberal constituencies—for a campaign to provide the additional fiscal backing that the economy needs in coming years. Efforts to beat back the rush to austerity were overwhelmed. Instead, many of these constituencies have retreated and seem ready to make their stands on budget policy by defending specific programs important to the living standards of vulnerable populations.

Why Political Defense Is Not Enough in the Face of Austerity

However, this strategy gives up far too much ground and radically underestimates how hard it will be to protect vulnerable populations—and the public programs that serve them—when unemployment remains elevated for years.

The most obvious difficulty with this strategy is that elevated unemployment will swell these populations’ need for help, while diminishing the resources available to help them. Another difficulty concerns the interactions (or lack thereof) between the federal, state, and local budgets. Even if advocates for vulnerable populations successfully keep federal programs from being cut (a big if), a looming fiscal crisis in state and local governments will put intense pressure on state-level programs. Further, fiscal austerity leads directly to private sector austerity. By putting upward pressure on the unemployment rate, a move toward fiscal austerity also puts downward pressure on private sector growth in wages and incomes. Further, because health insurance and pension coverage in the U.S. depend largely on access to full-time employment, coverage rates for health insurance and pensions also fall as the economy sputters. Lastly, the rush to austerity in response to short-term budget deficits (essentially caused by the recession) could threaten to lock in permanent austerity for many Americans if the response includes radical cuts to the major social insurance programs (Social Security, Medicare, and Medicaid).

The Economic Context

In April 2011, employment in the U.S. economy stood roughly eleven million jobs below the level that would be needed to return the unemployment rate back to prerecession levels. This includes the seven million jobs lost since December 2007, as well as the 3.8 million jobs that are needed over a thirtyeight-month period just to absorb a growing number of potential workers without pushing up the unemployment rate.

In March 2011, a monthly gain of 216,000 jobs was widely heralded as the most promising labor market development in many months. Yet it essentially moved the jobs gap from 11.1 million to eleven million—meaning that, at this month’s pace, the pre-recession unemployment rate would be reached again in late 2018—a full eleven years after the recession began.

And this agonizingly slow growth occurred in an economy with fiscal policy essentially set on neutral. As fiscal austerity digs in, there is little reason to think that this growth pace will be appreciably quicker—it may actually slow down. How can we be so sure? For one, there’s a large body of academic literature—including recent comprehensive work from the International Monetary Fund (IMF)—showing that contractionary fiscal policy is, indeed, contractionary.1 For another, we have a decent test case in the United Kingdom’s embrace (about a year ago) of austerity. Since those cuts began, the U.K.’s economy has actually slightly contracted for half a year. Yet U.S. policymakers remain determined to follow their transatlantic brethren down this path.

The Economic Consequences of High Unemployment

The consequences of prolonged high unemployment on American workers and their families will be grave. Before the rapid march to fiscal austerity began, the non-partisan Congressional Budget Office (CBO) forecast that pre-recession unemployment rates will not be reached again until 2016—a full nine years after the recession began. Cumulatively, this translates into roughly thirty-four million person-years of excess unemployment—that is, unemployed time over and above that which would characterize an economy working at its full potential during that period. Further, this rise in overall unemployment has also been accompanied by a similar rise in underemployment (i.e., involuntary part-time work) and a very large decline in the overall labor force, as roughly three million workers have stopped looking for work since the recession began.

Unequal Burdens

Further, it should be noted that the burden of unemployment is not shared equally across the labor force. African-American unemployment rates, for example, are roughly double the white unemployment rates, in good times and in bad. So the percentage-point increase in unemployment rates for African-Americans between 2007 and 2010 has been substantially higher than for white workers (7.7 versus 4.6 percentage points). Similarly, unemployment rates for workers without a four-year college degree (still nearly 70 percent of the overall workforce) tend to be roughly double those for workers that do have four-year degrees. This pattern of more vulnerable workers, and communities bearing a larger burden from increased overall unemployment, recurs as we examine the fallout from economic downturns. It is safe to say that recessions and the scars they leave are extraordinarily regressive events.

Not Just Jobs and Hours, but Pay and Benefits

A durable economic finding is that elevated unemployment puts downward pressure even on the wages of still-employed workers. Admittedly hypothetical forecasts estimate that, for the entire 2007-2016 period, median wages will be 15.6 percent lower and incomes of families in the middle quintile will end up 26.3 percent lower, should the CBO estimates hold.2 This is as useful a reminder as one can have about fiscal austerity translating quickly into private sector austerity for most American workers.

Further, the impact of elevated unemployment rates on the bargaining power of American workers is not uniform—workers at the bottom and middle of the wage distribution (and families at the bottom and middle of the income distribution) are much more sensitive to changing unemployment rates. While it’s better for all workers to have tight labor markets, a wage hit caused by elevated unemployment is clearly harsher on workers at the bottom and in the middle.

The clearest-cut case of this differential effect concerns the predictable rise in poverty and health care coverage rates that accompanies recessions. While rising inequality has kept poverty from falling quickly even in times of decent economic growth, when the economy enters a recession poverty rates spike—the rough rule of thumb is that one percentage-point increase in the overall unemployment rate leads to a 0.4 percentage-point increase in the share of people living under the poverty line. Again, this increase in poverty is not uniform. The poverty rate of African-Americans, for example, has been extraordinarily responsive to changes in the unemployment rate—each percentagepoint increase in the overall unemployment rate leads to a roughly 1.6 percentage-point increase in the African-American poverty rate.

Similarly, as unemployment rises and hours are cut back, the share of the workforce (and their families) covered by employer-sponsored health insurance craters. The rough rule of thumb is that every percentage-point increase in the overall unemployment rate leads to a 0.9 percentage-point reduction in the share of the under-sixty-five population covered by employer-sponsored insurance (the over-sixtyfive population is universally covered by the single-payer Medicare system). And, again, this decline in coverage has not been uniform since the recession began—workers in the bottom wage quartile are 13 percent less likely to be covered by employer-sponsored insurance in 2009 relative to 2007 (the year before the Great Recession), while workers in the top wage quartile are just 1 percent less likely.

Relying on Social Insurance While Accepting Austerity Won’t Work

Of course, the rates of coverage provided by public sources (predominantly Medicaid) have been able to absorb much (but not all) of the rise in people not covered through their jobs during this recession. But, as the boost to Medicaid spending provided by the ARRA wanes, more and more states are looking to cut their Medicaid spending. Again, relying on particular programs—even those as large and well established as Medicaid—to pick up the pieces of a poorly performing macroeconomy may become untenable pretty quickly: austerity begets austerity.

This can be seen most vividly in the budget proposal promoted by GOP Budget Committee Chairman Paul Ryan—a proposal endorsed by essentially the entire GOP House caucus. The Ryan plan calls for steep cuts in Medicaid right away. The irony, of course, is that the political rush to austerity—that has enabled truly radical plans like Ryan’s to gain respectability—has been driven overwhelmingly by the side effects of the Great Recession (i.e., very large increases in budget deficits).

The federal budget deficit was only 1.2 percent of GDP in 2007—a level that nobody would claim is ruinous or even particularly damaging. Yet by 2009 (after the Great Recession hit), it reached over 10 percent of GDP. When incomes fall during recessions, tax collections follow. When unemployment rises and wages fall, safety-net spending rises. Fully half of the increase in the budget deficit since 2007 is driven mechanically by the recession. Another quarter can be explained by the explicitly temporary policy responses—the ARRA as well as other extensions to unemployment insurance—meant to ameliorate the recession. The balance of the increase can be attributed to continued war spending.

Yet this rise in the budget deficit in the past three years has elicited an extravagant political response that has nothing to do with the origins of the deficit and its more modest dimensions. Multiple commissions—staffed with former White House and congressional luminaries—have pronounced the deficit, and not unemployment, as the primary emergency. The commercial media seems incapable of writing about the budget without characterizing the deficit as “enormous” or a “tidal wave.” Legislative proposals that have been floating around would forever gut the crown jewels of social insurance in the United States (Social Security, Medicare, and Medicaid) as well as cap how much could be spent in the long run on public investments and income supports to vulnerable populations.

This dynamic—poor economic performance leading to higher budget deficits which lead to political pressure to cut key social programs to close the budget gap—is what makes the strategy of ignoring macroeconomic policy decisions and hunkering down to defend key social programs so tenuous. That is, not only does a program like Medicaid have a much larger population to serve as the economy begins under-performing, but it will also come under much more intensive political attacks undertaken in the name of solving the budget gaps that inevitably rise during recessions. In this case, the root cause of both Medicaid’s population swell and the rising budget deficits—the recession and sluggish recovery—should be the primary focus of policymakers.

The Clear Danger of the Rush to Austerity

Any rush to permanently balance the federal budget will inevitably bring the social insurance programs— Social Security, and especially Medicare and Medicaid—into the crosshairs. Since these programs (along with those of the Pentagon) constitute the lion’s share of the current budget—and because medical costs are rising far faster than all other costs—this means they will be the biggest factors driving up costs in coming years.

The progressive response to the longrun rise in these programs’ costs is pretty straightforward. First, meet these costs partly through raising revenue (i.e., by restoring the tax rates on capital income to match those of labor income), with a particular focus on progressive revenue sources. Then, help meet other pressing economic policy targets (i.e., via carbon taxes to fight climate change or financial-transactions taxes to reduce damaging financial speculation). And, finally, implement reforms that slow the growth rate of medical costs (i.e., by adding a public option to health care reform and undertaking more aggressive bargaining with providers under government health-spending plans).

Needless to say, it would be a disaster if political opportunists with longstanding objections to these programs leveraged concerns about large, near-term, recession-induced deficits to weaken the pillars of American social insurance. However, that seems to be a real danger; the divided government—a Democratic president and Senate versus a GOP House—may represent the worst possible constellation for this scenario. The GOP’s hostility toward fiscal support in the short run surely stems, in part, from its calculation that it doesn’t “own” the economy’s performance before the 2012 elections.

However, the GOP’s cynicism has been aided and abetted by too many Democrats afflicted with irrational fears about recent budget deficits. This largely bipartisan unwillingness to give the economy the dose of fiscal support it needs to fully recover from the Great Recession is not just bad short-run economics—it also threatens to increase Americans’ already large sense of nihilism about the government’s ability to aid economic growth and prosperity. Just three years out from the worst economic crisis in a generation—caused by private sector profligacy—the debate has already turned back to the limits and evils of government.

 

Notes:

1. “Will It Hurt? Macroeconomic Effects of Fiscal Consolidation,” World Economic Outlook (Washington, D.C.: International Monetary Fund, October 2010), chapter 3.
2. Josh Bivens and Heidi Shierholz, “The Labor-Market Consequences of the Great Recession” in Gerald Epstein and Martin Wolfson, eds., The Oxford Handbook on the Political Economy of Financial Crises (New York: Oxford University Press, forthcoming).