Budget Austerity: Is It the Right Move
for the U.S. Economy?

While some groups in America scream that we need more austerity (cuts in government spending), something surprising is occurring: the U.S. government budget deficit is shrinking. Goldman Sachs recently issued a report reducing the estimated fiscal red ink for 2013 from $900 billion to $775 billion, a drop of 13.9%. As a percentage of Gross Domestic Product (GDP), this lower deficit comes in at 4.8%. In 2008, the deficit as a percentage of GDP exceeded 10%, so this is good progress. The same Goldman report projects the budget deficit to fall to just 2.7% of GDP by 2015, which many economists believe is a sustainable level. Could it be that the sky is not falling after all?

Still, senior members of the International Monetary Fund (IMF) are criticizing Washington policymakers for imposing too much budget austerity, too soon, arguing that it is preventing the unemployment rate from coming down more quickly. At the same time that the U.S. budget deficit is shrinking, one of the main pillars of the austerity movement has suffered a serious blow.

Harvard professors Carmen Reinhart and Ken Rogoff published their book, Growth in a Time of Debt, in January 2010, which forcibly argued that bad things happen to economies when government debt reaches more than 90% of GDP. The U.S. federal debt level ended 2012 at 72.5% of GDP. The professors asserted that whenever countries reached overall government debt levels of 90% of GDP, they experienced negative GDP growth, a recession, in aggregate over the countries studied.

Enter University of Massachusetts-Amherst graduate student, Thomas Herndon, who destroyed Reinhart and Rogoff’s credibility by discovering that their research was riddled with errors. Herndon noted that the spreadsheet used by Reinhart and Rogoff to ground their claim excluded data from Australia, Austria, Belgium, Canada, and Denmark. Canada looks more like America than any other country on the planet. Excluding economic data from Canada is like excluding your twin sister in a health study.

When the full data is included, countries crossing the 90% of GDP debt level, in aggregate, experienced 2.2% positive growth. Score +1 for UMass and -1 for Harvard. Why is this important? Because countries that have embraced austerity (Greece, Spain, Portugal, and the United Kingdom) are experiencing serial recessions for their efforts — just the opposite of what the flawed Reinhart/Rogoff data predicts. The United States, which opted for a stimulus approach to the 2008 meltdown by increasing government spending and debt, is recovering faster than any developed country in the world.

Nothing is more important in this context than getting the economy growing again. A healthy economy lowers deficits by bringing in more tax revenues (Goldman Sachs reports that U.S. tax revenues are up 12% over last year), and it further lowers the debt-to-GDP ratio by expanding GDP. Nobody argues that America should keep piling up debt forever, but it seems clear that the stimulus efforts after the Great Recession were the right thing to do. In contrast, the austerity efforts after the Great Recession are producing serial recessions.