Ed Dolan's Econ Blog

Budget Deal is a Victory For Deficit Hawks, Loss for Economy

A proposed budget deal brokered by Senator Patty Murray and Representative Paul Ryan is headed for the Senate after passing a the House on a bipartisan vote yesterday. [Update: The Senate passed it by a 2-to-1 margin on December 18.] Not everyone is happy about it. Conservatives would have liked to see more new deficit cutting measures. “In the coming days, members of Congress will have to explain to their constituents what exactly they achieved by increasing spending, increasing fees and offering up another round of promises waiting to be broken,” grumbled Michael Needham of Heritage Action. Many liberals are unhappy with the deal, too. “Here we are still having the conversation about how to cut government instead of how to improve the prospects of the long-term unemployed and improve the overall economy, which would take expanding spending, not shrinking it,” economist Laura Dresser lamented to The Progressive.

With both the right and the left denouncing the deal, who is the real winner? If we look at the numbers, it is hard not to conclude that the pending deal, which would lock in the status quo, is a victory for the deficit hawks who have pretty much had their way with fiscal policy in recent years. True, on the downslope of the recession, first the Bush and then the Obama administrations tried fiscal stimulus. Without their actions, the downturn would very likely have been even deeper. However, the stimulus has long since run its course. Since the recovery officially began in mid-2009, fiscal policy has tightened markedly.

Some people evidently don’t believe that. The Tea Party News Network, for example, continues to rant about “years marked by runaway spending and out-of-control deficits,” but those years ended some time ago. To see what has really been going on, we need to take a closer look at the evolution of fiscal policy over the course of the Great Recession and the still-incomplete recovery from it.

The broadest indicator of the stance of fiscal policy is the primary structural balance (PSB)—the government’s surplus or deficit adjusted to strip away the impact both of the business cycle and of interest payments on past debts. The orthodox view is that the PSB should show a slight surplus, on average, over the business cycle, with the size of the appropriate surplus depending on interest rates, the rate of economic growth, and the level of the deficit accumulated in the past. Using the PSB as a benchmark, we can identify three possible patterns of fiscal policy:

  • If the PSB is constant over the course of the business cycle, the actual budget will move into deficit when the economy dips into recession and into a larger than normal surplus during a boom. That pattern of policy is cyclically neutral.
  • A countercyclical fiscal policy attempts to smooth the business cycle by using discretionary tax cuts or spending increases to move the PSB toward deficit during a recession, and by using tax increases and spending cuts to prevent overheating during a boom.
  • A procyclical fiscal policy amplifies the business cycle rather than smoothing it. It does so by using tax increases and spending cuts to move the PSB toward surplus when the economy is operating below potential and then cutting taxes and increasing spending in times of prosperity.

As the following chart shows, U.S. fiscal policy since 2009 has been distinctly procyclical. The line labeled “output gap” measures the amount by which the economy is above or below its potential level of real output, that is, the level needed to achieve full employment, now thought to be something around 6 percent for the United States. Despite the large negative output gap, fiscal policy has steadily tightened since 2009, as shown by the movement of the PSB toward surplus. The points for 2014 and 2015, which show further movement toward surplus, are estimates based on the assumption that fiscal policy would follow the path set by existing law. They were made before the recent budget agreement was proposed, but since the deal focuses on details of spending and revenue with little or no effect on the overall budget balance, those estimates are unaffected.

Output gaps and primary structural balances may strike some readers as excessively abstract concepts, so let’s look at a couple of additional charts that underline the degree of fiscal austerity over the past four years.

The first of these shows the government sector’s contribution to GDP growth. The federal contribution has been negative in ten out of the last twelve quarters, reinforced, in most of them, by further budget tightening on the state and local levels. In plain English, fiscal austerity has made a slow recovery even slower than it would otherwise have been.

The next chart shows the share of federal workers in the civilian labor force, another common-sense measure of the size of government. Since the peak of the 2009 stimulus and the end of temporary hiring for the 2010 census, the path of federal employment has been steadily downward. It is now lower than the lowest level reached during the Bush administration.

The bottom line: Although it is being sold as a pragmatic centrist compromise, the Murray-Ryan budget deal, which locks in the pattern of procyclical fiscal austerity established over the past four years, is a victory for deficit hawks. Unfortunately, it is less of one for the economy, since efforts to shrink the deficit during a period of weak demand and elevated unemployment inevitably slow the recovery.

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10 Responses to “Budget Deal is a Victory For Deficit Hawks, Loss for Economy”

ThomasGrennesDecember 16th, 2013 at 9:05 am

Isn't short-term fiscal policy connected to long-term policy? If so, a potential bargain could
consist of more expansionary current fiscal policy in return for less expansionary long-term policy. This opportunity was missed again, and it results in pro-cyclical policy and a
tighter squeeze on discretionary spending that includes infrastructure, R&D, and education. Notice that government employment becomes a poorer measure of government size as the proportion of spending on transfer payments increases. The failure to reach a grand bargain that includes automatic spending on Social Security, Medicare, and Medicaid comes at a high cost.

KansasnoallDecember 17th, 2013 at 10:00 am

“First get the facts. Then you may twist them at your leisure.” – Mark Twain

Your employees as a per cent of civilian employment causes me to question because I have seen similar illogic in the corporate world. If I create a product and out source most of the labor to create the product/service, have I reduced the labor per unit of production? On a similar note, until one accounts for employment related to all out sourced government functions and entitlements (those dependent on the gov for food and shelter), has one accounted for all gov labor versus all civilian labor? Does your gov labor versus civilian labor chart justify your conclusion, but not accurately tell how many are dependent on the government for food and shelter versus how many civilian workers are in the work force? I would like to see an article and chart on the number of citizens that gain their food and shelter from government versus the number of citizens that gain their food and shelter from civilian labor. The chart would give a more accurate view of whether our nation is still deficit spending or not; if I am to assume your assumption that gov labor versus civilian labor is a good metric to determine such things.

Ed Dolan EdDolanDecember 18th, 2013 at 7:35 pm

Your point is one worth addressing. If we saw that government spending was going up but employment was going down, we would get suspicious. Then outsourcing would be a good explanation.

I have tried to cover that base by including the data on "government contribution to GDP." To get a little technical, what the chart shows is a series called "government consumption expenditures and gross investment." It includes both the salaries of all government employees and anything paid to government contractors. You can see, then, that outsourcing would affect the number of government employees but it would not affect GCEGI. Your hypothesis is that GCEGI is still going up even though government employment is going down. In fact, both are going down.

windrivenDecember 17th, 2013 at 11:40 am

"a victory for the deficit hawks who have pretty much had their way with fiscal policy in recent years."

How so? We currently have federal debt topping $17 million million – a substantial sum even by Washington standards. I don't think this can be be characterized as the result of deficit hawks having had their way. I think a more accurate characterization would be fiscal policy wobbling between feckless and nonexistent.

That stimulus was required is obvious. But the benefit of Bush-Obama stimulus was enjoyed disproportionately – wildly disproportionately – by the financial sector. Res ipsa loquitur.

My fear is the consequence to the economy when interest on federal debt returns to historically more normal levels. Interest at 5 percent would result in debt service cost in the neighborhood of $850 billion per year. For perspective, the US defense budget is in the neighborhood of $725 billion.

Ed Dolan EdDolanDecember 18th, 2013 at 7:40 pm

My definition of a "deficit hawk" is a person who thinks that cutting the deficit is so important that it is worth doing even when the economy has not yet recovered. There are two rational reasons that I can see to be a deficit hawk in this sense.

(1) You don't care about recovery of employment, middle class incomes, etc. Corporate profits have fully recovered, and that is enough for you, so cut away at the rest.

(2) You agree that in an ideal world, it would be better to "fix the roof when the sun is shining," that is, undertake countercyclical deficit cutting measures when the economy is doing well and cutting the deficit will help prevent overheating and asset bubbles. However, you do not trust Congress to do that. The only time you can get them to focus on the deficit at all is when you are in a slump that makes it even larger than it otherwise would be.

Do either of these fit your views, or do you have something else in mind? Please comment further.

windrivenDecember 19th, 2013 at 12:40 pm

Ouch. I must have been having one of my less articulate moments when I wrote that. I certainly do not believe (1). I have actually hired till it hurts at my US plant in an effort to 'do my part.'

(2) is much closer. But I was really expressing (a) that I have not seen a coherent fiscal policy from the administration – other than to deliver hot and cold running backrubs to Wall Street, (b) that the 'deficit hawks' are really more accurately tax hawks and that their motivation seems to closely resemble your point (1), and (c) that I do believe that the deficit poses a potent long term risk and that while today is too soon to start managing it, tomorrow (figuratively speaking) shouldn't stretch too much further.

I am a physicist and entrepreneur, not an economist. But I worry that a recovery that seems slow to generate jobs and slower still to generate well-paying jobs is not the sort of recovery that will drive growth that will translate into increased tax revenues with which to manage inevitable higher debt service costs. A recovery that generates corporate profits but not disposable income for the middle class is a recovery that starves the Treasury because large corporations have become quite adept sheltering income and are likely to become more adept as they see the success of their peers.

Ed Dolan EdDolanDecember 19th, 2013 at 1:18 pm

Well put. I like your characterization that deficit hawks=tax hawks. Often true, especially apparent in their rejection of deals that would close the deficit with x dollars in new taxes and y dollars in spending cuts, even when y is considerably larger than x. Also their rejection of tax-neutral loophole-closing reforms.

BTW, I did not mean to say that you personally believed (1), just that it was one possible reason to be a deficit (or tax) hawk.

windrivenDecember 17th, 2013 at 1:01 pm

Dr. Dolan, isn't it arguable that government spending isn't so much too low as that it is misallocated? By that I mean to suggest that the large and ever increasing portion of government spending on entitlement programs starves the government of cash for other uses that would more directly benefit the economy in general. If this is true it wouldn't be so much an issue of deficit hawks as tax hawks (which arguably is the better descriptor for the tea party and some other conservative groups).

This suggests that we either abrogate our social contract with seniors and the poor or that we raise taxes so as to fund both entitlements and a sound fiscal policy. I would further argue that increased federal transparency and efficiency would make a higher tax burden more palatable. By way of example I offer Denmark and Sweden, countries with a much higher tax burden but relatively little serious tax reduction sentiment. Both of these countries, for instance, provide excellent cradle to grave health care for substantially all of their citizens for about 10% of GDP while the US spends 18% and provides high quality care only for those who enjoy good insurance.

In short, the federal government needs to tune up its value proposition and sell that proposition to the American people. Kind of like a struggling business 😉

Ed Dolan EdDolanDecember 18th, 2013 at 7:44 pm

If I understand you correctly, I agree. Part of the increase in entitlement spending is due to an aging population. It would make sense to raise taxes to cover that part. Then we would not have to shortchange discretionary programs that focus on the future (education, research, infrastructure, public health, etc.) in the name of cutting the budget. Of course, there are other elements of entitlements that have nothing to do with aging, for example, excess growth of heathcare costs compared both with what we get and with what other countries get.

windrivenDecember 19th, 2013 at 12:46 pm

"[T] here are other elements of entitlements that have nothing to do with aging, for example, excess growth of heathcare costs compared both with what we get and with what other countries get."

Health care costs in this nation are insane. By my calculation based on comparisons with Sweden and Denmark (countries I chose because I have significant experience there) the US wastes roughly $1.25 trillion dollars each year to achieve essentially equivalent care. $1.25 trillion would go a long way toward filling gaps in research, education and infrastructure funding. But ACA stands as proof positive that the political will to address this problem does not exist in this country.