Did you notice how the U.S. economy was suddenly thrown into recession this year when tax increases and spending cuts took effect? If you didn’t, that’s no surprise because the economy actually accelerated to 2.5% growth in the first quarter of 2013 from just 0.6% growth in the fourth quarter of 2012. Preliminary estimates for growth in the second quarter suggest that growth will remain close to 2%, about the same trend rate achieved since the recovery began in 2009. The policy changes – especially a forecast 5.6% cut in discretionary spending – have had virtually no impact on growth rates, but have succeeded in reducing the deficit by $445 billion or 3% of GDP.
It’s fascinating to consider the success of proactive deficit reduction is coming at a time when people like Paul Krugman are trumpeting the intellectual collapse of the “austerity” movement. The hardcore left in the U.S. and abroad opposes any reduction in government expenditure no matter when it occurs. Increases in government purchases can serve a useful purpose when the economy is a state of free fall, as was the case at the beginning of 2009. But the recovery has been underway for four years; a continuation of annual deficits in excess of $1 trillion simply increases the expected future tax burden associated with servicing that debt, which reduces spending and investment today.
The biggest impact from the move towards “austerity” was expected to come from the $100 billion increase in payroll taxes as a result of the expiration of the 2% payroll tax holiday on December 31, 2012. Many forecasters expected household spending to fall in the first quarter in response to the decline in take-home pay. Instead, household spending increased at an annual rate of 4.1% in the first quarter, up from 3.5% growth in the fourth quarter of 2012 (measured in current dollars). The increase occurred because savings rates declined and consumer credit increased. If households recognize that a tax cut is likely to be reversed, the rational response would be to save some of the tax cut today and spend it on purchases tomorrow. That appears to be exactly what happened, as household savings increased to 4% in response to the 2011-2012 payroll tax cut and then declined to 2.6% in the first quarter of 2013.
This lesson is important for conservatives to learn as well. Opposition to tax increases necessitates reductions in spending. If taxes are cut while spending rises, households may begin to expect that taxes will be raised in the future whether or not the tax cuts are “permanent” or scheduled to expire. In addition to being raised to reduce unsustainably large deficits, tax increases will also be needed to offset interest costs associated with the borrowing used to finance the original round of tax reductions.
Austerity’s supposed failure in Europe is an example of fitting evidence to one’s preconceived idea about reality. The problems in Italy, Spain, Greece, and Portugal are a product of suffocating regulations that create structural impediments to hiring, an insolvent banking sector that is depriving small businesses of needed credit, and excessive government spending and debt ratios. Blaming “austerity” for problems in Europe is outrageous; strict adherence to budget targets may not be helping matters, but insufficient government spending is the least of Europe’s problems, especially given the much more acute risk of losing access to credit.
The United Kingdom chose “austerity” willingly, as the Bank of England (BOE) could fund the gilts market to avoid a funding crisis similar to one that erupted in the eurozone. Yet, the real spending cuts are only kicking in now, just as the economy is finally expanding. Prior tax increases likely didn’t help matters, but they were hardly the driver the economic malaise that has its roots in the economy’s overreliance on financial services and sharp decline in workforce productivity. The U.K. is now actively cutting future taxes by reducing the interest expense that would have otherwise been required to service a continuation of large deficits.
Of course, no matter what happens with the economy, government spending enthusiasts could argue that growth would have been that much faster in the absence of “austerity.” But how believable is this claim? Between June 2010 and December 2012, the U.S. economy expanded at an annualized rate of 2.0%. Does anyone really believe that growth would have magically accelerated to 3.0% to 3.5% in the absence of the year-end policy changes? This is precisely what one has to believe to think “austerity” has had the advertised effect given that the economy is currently growing near the same 2% rate as it has for the past three years. Much more likely is that deficits and uncertainty about how they’d be resolved reduced spending in 2011 and 2012 and tax increases and spending cuts have a less than proportionate impact on household spending today.
The deficit fight is far from over. At 4% of GDP, budget deficits remain well above levels consistent with debt stabilization. The entitlement problem is as big as ever. The recent experience should prove catalytic in this regard, as it teaches lawmakers that they need not be spooked about the impact spending cuts will have on growth rates.
