Tag Archives: DEFICIT

When Cutting Doesn’t cut the Deficit

This is a great illustration of how cutting spending may actually raise the deficit.  We need to address the deficit now, but I think most the cutting needs to in the near future.  Not right now.  We’re still in a modest recovery.

From "The Streetlight"

 

Here’s a short lesson about something that every policy-maker should have learned in Macro 101, but apparently has been forgotten by many of them.

Suppose we are in a country that is running a large budget deficit but, for whatever reason, decides that it needs to dramatically reduce it. Take your pick of examples, because there are plenty to choose from: Greece, the UK, the US…

Suppose that the country – let’s call it Austerityland – has a GDP of $100/year, and a budget deficit of $10/yr, or 10% of GDP. And suppose that the government decides it wants to get the deficit down to 5% of GDP. How can it get there?

No, the answer is not “cut spending by $5/yr”. Nor is it “raise taxes by $5/yr”. And last but not least, it is also not “enact a combination of tax increases and spending cuts that total $5/yr”. To see why, let’s do just a bit of arithmetic.

To keep things simple (and to make it particularly relevant to the three examples mentioned above), let’s focus on the strategy of trying to halve the budget deficit primarily through spending cuts. So the government of Austerityland decides to cut spending by $5/yr. What happens?
Recall that GDP is the sum of spending on final goods and services by domestic consumers, domestic businesses, and the government, along with net exports:

GDP = C + I + G + (X – M) = Y.

Recall as well that GDP is, for our purposes, the same thing as income (Y).

If G is reduced by $5 in Austerityland, the first thing that happens is that GDP falls by $5. But then a bunch of secondary effects kick in, including:

  • C falls, since individuals in the economy have seen their income drop by $5. This makes GDP fall even further. This is called the “multiplier effect”, and it means that the total fall in GDP is likely to be substantially greater than $5. (Empirical research seems to usually show that the government spending multiplier is in the neighborhood of 1.5, implying that the net fall in GDP will be around $7 or $8.)
  • If interest rates are positive, they will tend to fall as demand diminishes, which could boost spending by businesses. But if interest rates are already at zero (as they are effectively are in the US), they will not fall, and we get no boost to private investment.
  • Tax revenues fall as income falls. If the effective marginal tax rate on income is 25% and income falls by $4, for example, then tax collections will fall by $1.

So, what is the budget deficit in Austerityland after a $5 reduction in government spending? If we assume a relatively modest multiplier of 1.5, and a tax rate of 25%, then we get:
ΔG = -$5
ΔY = -$7.5
ΔT = -$1.875

And the new deficit is now $6.875, which is 7.4% of the new level of GDP. Wait, I thought we were trying to get the deficit down to 5% of GDP? What happened?

What happened is that we’ve missed our target, by quite a bit, due to the multiplier effect and the fall in tax revenues that resulted from the shrinking economy. In fact, just a bit of simple algebra allows us to figure out that government spending in Austerityland will have to be cut by about $9 in order to reach a budget deficit target of 5% of GDP. In other words, the government will have to cut spending by almost twice as much as it initially thought it would in order to reach its deficit target.
(When that happens, by the way, GDP will fall from $100 to around $86. Yes, that’s a 14% drop in output. But hey, at least we’ve hit our deficit reduction target!)

Somehow, this simple exercise in macroeconomic math seems beyond the reach of policymakers around the world.

  • Many Republicans (and some Democrats) in Washington continue to believe that they can close a $1 trillion deficit by simply cutting $1 trillion in spending, and are apparently hoping to use the debt ceiling vote to do exactly that.
  • The Cameron government in the UK embarked on an austerity program last year to try to reduce its budget deficit, and now mysteriously keeps missing its deficit reduction targets as the UK economy shrinks.
  • The Greek government was forced into enacting a number of austerity measures last year, and… surprise, surprise… is now missing its deficit targets.

Why do people keep getting surprised that austerity doesn’t work as well as hoped to reach budget deficit targets? I know, I know, there are people who argue that basic Macro 101 has it all wrong. Even people who know better (ahem, Douglas Holtz-Eakin) somehow allow ideology to get them to make the bizaare claim that when income goes down, people will actually increase spending. Confidence fairies and all that.
But when basic Macro 101 both makes good theoretical sense and also fits what we actually observe, it’s really time to start looking for your handy Occam’s Razor. I wish I could take more satisfaction from the fact that mainstream macroeconomics, as it has been taught to first-year college and university students around the world for decades, does such a good job explaining what we see happening across the globe today…

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CEA Chairs on the Budget Deficit

 

Click here to read an important article signed by a bipartisan group of ten former chairmen and chairwomen of the Council of Economic Advisers.  I have never before had such a large and distinguished group of coauthors.

CEA Chairs on the Budget Deficit
Greg Mankiw
Thu, 24 Mar 2011 08:46:00 GMT

Advise Conservatives Should Listen to

I voted for Barack Obama, and am undecided for 2012.  So maybe I’m up for grabs as a voter.

Why did I vote for him 2008?  Mostly the war.  I hoped he wouldn’t as carelessly commit our troops as President Bush did.  So far he hasn’t, so that a reason to vote for Mr. Obama again.

But time marches on and issues change.  What is the big issue now?  I’d say the deficit.  So far I’m disappointed in this president.  I had hoped he would let the Bush tax cuts end, and move to use his liberal credentials to rain in spending at the same time.  This would have been similar to the strategy of President Clinton.  Instead, he seems to have moved to extend the tax cuts in exchange for more spending.

But what is the alternative?  The Republicans are very much coconspirators in the plan to make the deficit even bigger!  On foreign policy at least there seem to be voices of dissent from the jingoism of the Bush years and 2008.  All in all though, I think jingoism is where the GOP is till mostly at.  How do we attack the deficit unless defense is on the table, and I’m not sure it is for most Republicans.

Also, do conservatives seem like they have a sane alternative to Mr. Obama?  Do they seem coherent?  Not so much.  They spend most of their time discussing the most outrageous charges about the President, not the specifics of his policies.

All that said, it is heartening to read this by Michael Medved in the Wall Street Journal.  Maybe the Republicans can become a serious party again.  Let hope others read and listen to this:

Some conservative commentators may feel inclined to spend Presidents Day ruminating over Barack Obama’s evil intentions, or denouncing the chief executive as an alien interloper and ideologue perversely determined to damage the republic. Instead, they should consider the history of John Adams’s White House prayer and develop a more effective focus for their criticism.

On Nov. 2, 1800, a day after he became the first president to occupy the newly constructed executive mansion, Adams wrote to his wife Abigail: "I pray Heaven to bestow the best of blessings on this house and all that shall hereafter inhabit it. May none but honest and wise men ever rule under this roof."

More than a century later, Franklin Roosevelt ordered the inscription of these words on a mantel piece in the State Dining Room, inviting serious consideration over the extent to which divine providence responded to the earnest entreaty of our second president.

In terms of wisdom, some of Adams’s successors who "ruled" under the White House roof most certainly fell short. James Buchanan comes to mind—or Jimmy Carter.

When it comes to honesty, skeptics might also cite heaven’s mixed blessings, reviewing a long history of presidential prevarication. Richard Nixon almost certainly lied about Watergate, as did Bill Clinton about his amorous adventures.

But in the deeper sense that Adams longed for "honest men" to occupy the White House, the nation has fared much better: Those who rose to the highest office worked hard, took their responsibilities seriously, and sincerely pursued the nation’s good—in order, if nothing else, to secure a positive verdict on their own place in history.

Even the most corruption-tarred presidents, Ulysses S. Grant and Warren G. Harding, agonized over the demands of the office and drew scant personal benefit from the scandals involving unworthy associates. They both retained the profound affection of the populace while they lived and drew massive outpourings of grief at their funerals. Both (especially Grant) have begun a recent rise in the estimation of historians.

John F. Kennedy may have suffered from sex addiction (and a host of other secret maladies) while Franklin Pierce drank heavily in the White House (in part in mourning for his 11-year-old son who died before his eyes in a train accident two months before the inauguration). But neither man ignored his duties, and both had previously demonstrated their love of country with courageous military service.

Associated Press (2)

Sarah Palin and Rush Limbaugh

In short, the White House record of more than 200 years shows plenty of bad decisions but no bad men. For all their foibles, every president attempted to rise to the challenges of leadership and never displayed disloyal or treasonous intent.

This history makes some of the current charges about Barack Obama especially distasteful—and destructive to the conservative cause.

One typical column appeared on Feb. 5 at the well-regarded American Thinker website, under the heading: "Obama Well Knows What Chaos He Has Unleashed." Victor Sharpe solemnly declares: "My fear is that Obama is not naïve at all, but he instead knows only too well what he is doing, for he is eagerly promoting Islamic power in the world while diminishing the West."

These attitudes thrive well beyond the blogosphere and the right-wing fringe. On Jan. 7, Sarah Palin spoke briefly on Laura Ingraham’s radio show, saying, "What I believe that Obama is doing right now—he is hell-bent on weakening America." While acknowledging that "it’s gonna get some people all wee-weed up again," she repeated and amplified her charge that "what Obama is doing" is "purposefully weakening America—because he understood that debt weakened America, domestically and internationally, and yet now he supports increasing debt."

The assumption that the president intends to harm or destroy the nation that elected him has become so widespread that the chief advertising pitch for Dinesh D’Souza’s best-selling book, "The Roots of Obama’s Rage," promises to "reveal Obama for who he really is: a man driven by the anti-colonial ideology of his father and the first American president to actually seek to reduce America’s strength, influence and standard of living."

None of the attacks on Mr. Obama’s intentions offers an even vaguely plausible explanation of how the evil genius, once he has ruined our "strength, influence and standard of living," hopes to get himself re-elected. In a sense, the president’s most paranoid critics pay him a perverse compliment in maintaining that his idealism burns with such pure, all-consuming heat that he remains blissfully unconcerned with minor matters like his electoral future. They label Mr. Obama as the political equivalent of a suicide bomber: so overcome with hatred (or "rage") that he’s perfectly willing to blow himself up in order to inflict casualties on a society he loathes.

On his radio show last July 2, the most influential conservative commentator of them all reaffirmed his frequent charge that the president seeks economic suffering "on purpose." Rush Limbaugh explained: "I think we face something we’ve never faced before in the country—and that is, we’re now governed by people who do not like the country." In his view, this hostility to the United States relates to a grudge connected to Mr. Obama’s black identity. "There’s no question that payback is what this administration is all about, presiding over the decline of the United States of America, and doing so happily."

Regardless of the questionable pop psychology of this analysis, as a political strategy it qualifies as almost perfectly imbecilic. Republicans already face a formidable challenge in convincing a closely divided electorate that the president pursues wrong-headed policies. They will never succeed in arguing that those initiatives have been cunningly and purposefully designed to wound the republic. In Mr. Obama’s case, it’s particularly unhelpful to focus on alleged bad intentions and rotten character when every survey shows more favorable views of his personality than his policies.

Moreover, the current insistence in seeing every misstep or setback by the Obama administration as part of a diabolical master plan for national destruction disregards the powerful reverence for the White House that’s been part of our national character for two centuries.

Even in times of panic and distress, we hope the Almighty has answered John Adams’s prayer. Americans may not see a given president as their advocate, but they’re hardly disposed to view him as their enemy—and a furtive, determined enemy at that. For 2012, Republicans face a daunting challenge in running against the president. That challenge becomes impossible if they’re also perceived as running against the presidency.

Mr. Medved hosts a daily, nationally syndicated radio show and is the author of "The 5 Big Lies About American Business" (recently out in paperback by Three Rivers Press).

Boehner backs off Social Security cuts

From Ezra Klein

The big concern that progressives had going into the State of the Union address was that President Obama would propose cuts to Social Security. That didn’t happen. And now, a few days after the State of the Union, John Boehner is backing off the cuts he’d previously proposed to Social Security.

Before the election, Boehner had said we should raise the retirement age to 70; he now says that proposing cuts was putting the cart before the horse. "I made a mistake when I did that because I think having the conversation about how big the problem is is the first step," Boehner told CNN’s Kathleen Parker. "And once the American people understand how big the problem is, then you can begin to outline an array of possible solutions." I take this as another example of the GOP’s flight from specificity.

Boehner backs off Social Security cuts
Ezra Klein
Thu, 27 Jan 2011 17:19:07 GMT

 

This doesn’t auger well for serious addressing of our fiscal situation.  I’m disappointed in Obama.  As a liberal, if he chose he has more potential to seriously address this than a right wingers.  It’s just like how Nixon could go to china.

From James Kwak

The deficit rag!!!

This post is very insightful coming from a deficit hawk who understands why that doesn’t any sense in the 2-4 years. We need ultimately to get our house in order, but not by making the recession deeper.

Here it is with input by your truly (in CAPS):

Last night I read a post by Brad DeLong that made me so mad I had trouble falling asleep. (Not at DeLong, mind you.) There’s really nothing unusual in there — hysteria about the deficit, people who voted for the Bush tax cuts and the unfunded Medicare prescription drug benefit but suddenly think the national debt is killing us, political pandering — but maybe it was the proverbial straw.

First, let me say that I largely agree with DeLong here:

I am–in normal times–a deficit hawk. I think the right target for the deficit in normal times is zero, with the added provision that when there are foreseeable future increases in spending shares of GDP we should run a surplus to pay for those foreseeable increases in an actuarially-sound manner. I think this because I know that there will come abnormal times when spending increases are appropriate. And I think that the combination of (a) actuarially-sound provision for future increases in spending shares and (b) nominal balance for the operating budget in normal times will create the headroom for (c) deficit spending in emergencies when it is advisable while (d) maintaining a non-explosive path for the debt as a whole.”

Now, let me tell you what I am sick of:

1.

People who insist that the recent change in our fiscal spending is the product of high spending, without looking at the numbers, because their political priors are so strong they assume that high deficits under a Democratic president must be due to runaway spending. And it’s not just Robert Samuelson.

PEOPLE WHO BUY THIS OBAMA THE BIG DEFICIT SPENDING DEMOCRAT HAVE NO CONCEPT THAT MUCH OF THE INCREASE IN THE DEFICIT THIS YEAR IS REDUCED REVENUES. I DON’T THINK THEY EVEN THINK ABOUT THIS.
2.

People who forecast the end of the world without pointing out why the world is ending. Here’s Niall Ferguson, in an article entitled “An Empire at Risk:” “The deficit for the fiscal year 2009 came in at more than $1.4 trillion—about 11.2 percent of GDP, according to the Congressional Budget Office (CBO). That’s a bigger deficit than any seen in the past 60 years—only slightly larger in relative terms than the deficit in 1942.” But does he mention that the reason for the 2009 deficit is lower tax revenues due to the financial crisis and recession? No. Here’s Ferguson on the 10-year projection: “Meanwhile, in dollar terms, the total debt held by the public (excluding government agencies, but including foreigners) rises from $5.8 trillion in 2008 to $14.3 trillion in 2019—from 41 percent of GDP to 68 percent.” Does he mention that, as early as January 2008, that number was projected to fall to 22%, and the majority of the change is due to lower tax revenues? No.

SAME POINT AS ABOVE

3.

People who posture about our fiscal crisis who voted for the Bush tax cuts — shouldn’t shame require them to keep silent?

THIS I HAVE MORE MIXED FEELINGS ABOUT: I LIKE TO GIVE PEOPLE BACK THEIR MONEY

4.

People who say, like Judd Gregg, “after the possibility of a terrorist getting a weapon of mass destruction and using it against us somewhere here in the United States, the single biggest threat that we face as a nation is the fact that we’re on a course toward fiscal insolvency,” as if this is a new problem, when it’s been around since 2004 (see Figure 1) — when, I might add, Judd Gregg was a member of the majority. (Tell me, was Niall Ferguson forecasting the end of the American empire in 2004, when everything he says now about long-term entitlement spending was already true? That’s a real question.)

DURING THIS PERIOD WE ALSO PASSED A DRUG ENTITLEMENT WITH NO MATCHING REVENUES, AND THE GOP SEEMS TO WANT TO PROTECT MEDICARE. ALL OF TODAY’S “CONSERVATIVES” ASSUME I THINK THAT THE DEFICIT IS SOMEHOW DUE TO TRANSFERS TO PEOPLE LESS WELL OFF THAN THEY. FURTHERMORE I DON’T THINK MOST CONSERVATIVES ARE UP FOR ANY PERSONAL SACRIFICE TO CURE THE DEFICIT.

5.

People who say that we can’t pass health care reform because it costs too much, ignoring the fact that the CBO projects the bills to be roughly deficit neutral, ignoring the fact that the Senate bill has received bipartisan health-economist support for its cost-cutting measures, and ignoring the fact that our long-term fiscal problem is, and always has been, about health care costs (see Figure 2).

THIS CONCERN I SHARE BECAUSE I THINK THE BACKERS OF THE REFORM MAY NEVER DELIVER THE CUTS INTENDED TO PARTIALLY PAY FOR IT. IF I COULD BE REASSURED ON THIS POINT I’D AGREE.

6.

People who say the Obama administration is weak on the deficit (Ferguson refers to Obama’s “indecision on the deficit”, and he is gentle by Republican standards), when by tackling health care costs head-on — and in the process angering their political base — they are doing the absolute most important thing necessary to solve the long-term debt problem.

AGREE

7.

People who cite “financial ruin” purely, absolutely, incontrovertibly as a political tactic to try to kill health care reform (courtesy of DeLong and Brian Beutler)…

ALMOST CERTAINLY TRUE. YOU USE THE DEFICIT TO DEFEAT LARGESS THAT YOU DON’T GET A PIECE OF.

8.

Joe Lieberman.

NOT SURE WHAT I THINK