The Roots of the Debt-Limit Crisis: Fear Is a Great Motivator, but Scared People Often Act Rashly and Foolishly

Posted in: Politics

The Great Debt Limit Crisis of 2011 has now been resolved, with a very messy and one-sided political deal, rather than a constitutional confrontation.  Many commentators are trying to assess who won and who lost, critiquing the strategies of the various participants, and trying to predict the political consequences for the President and the parties in next year’s elections.

All of those are important questions, in their way.  However, given that we have now embarked on a path that will only make a sick economy much sicker—quite possibly pushing the country back into recession—the more important question, in my view, is how we ever reached the point where both parties became committed to an economic strategy that is so detached from reality.  How did spending reductions become the all-consuming political topic of 2011, when more than 14 million American workers continue to be idled by the weak economy?

The answers to those questions boil down to the basic human failings of greed, ignorance, expedience, and fear.  Fear, above all, lies at the heart of this crisis.  Too many politicians were afraid to speak the truth, and too many were willing to exploit the fears of their constituents.  Economists and other policy analysts, too, were guilty of spreading fear.  As we have now seen, fear can cause people to take extreme actions, but once the public’s fear has been unleashed, it is nearly impossible to predict or control the path that a frightened people will follow.

It is time to change course, substituting understanding for fear-mongering.

Return to the Basics: This Is No Time for Deficit Reduction or Spending Cuts

The conversation in Washington often takes on a life of its own, with unspoken assumptions constraining actions and inhibiting clear thinking.  The totemic significance of “deficit reduction” as a presumed mark of sober realism is the outstanding current example of that phenomenon.  People no longer know why they favor deficit reduction or spending cuts, or whether there are nuances that are missing from the analysis. Instead, everyone has simply accepted that fiscal austerity is A Good Thing—even though the case for deficit reduction and spending cuts is currently nonexistent.

Earlier this summer, for example, I was being interviewed by a regional newspaper editor for a story about federal spending.  Throughout the interview, it was clear that the editor viewed deficit reduction as the unquestioned goal of good economic policy.  At one point, however, it suddenly occurred to him to ask, “You agree, of course, that deficits are too high?”  He was stunned when I said that they are currently too low.  He quickly closed the interview, and the piece was never published.

What could I have possibly meant by the idea that deficits are currently too low?  Is this some kind of esoteric, untested theory from some woolly-headed academic, with no connection to the real world?  Hardly.  It is only the most basic of the tenets of economics:  The government must step in when the economy is weak.  It is true that there are a few competing theories that attempt to discredit that basic truth, but it is those alternative theories that are disconnected from reality.

Budget deficits, of course, become larger when the government spends more money or collects smaller amounts of tax revenue.  Both of those things are good for a weak economy.  Businesses are currently refusing to hire workers because there are not enough customers, so there is no reason for businesses to hire people to make more goods, or to sell goods to the public.  When the government puts more money into people’s hands, either by buying goods from private businesses, or by sending checks to people (for example, providing benefits to unemployed workers), or by cutting taxes, this sets in motion the process by which the economy expands, profits rise, and people are put back to work.

It is also true, of course, that more spending by non-governmental actors could improve the economy.  Consumers could buy more goods, creating a virtuous cycle in which businesses then would hire more workers, who then could consume still more goods.  Alternatively, businesses could expand factories, buy more equipment, or build up inventories, all of which would also set in motion a self-reinforcing expansion.  Finally, foreign buyers could start to increase their purchases of our exports.

The problem, however, is that none of these three alternatives to governmental action can be counted on to break the downward cycle.  The same logic that stops businesses from hiring workers—the realization that there are not enough customers for what is already being produced—also keeps a lid on consumers’ spending (because they are worried about losing their jobs) and deters businesses from expanding their productive capacities.  And given that the rest of the world is also still trying to recover from the Great Recession, we can expect no help from exports.

The Weakness of the Leading Alternative Theory

Again, there are some economists and others who claim to have better theories of how the economy works than the one I have described here.  Probably the most widely repeated of those alternative explanations is the idea that a deficit creates uncertainty in the minds of business executives, who then hold back on hiring and expansion that would otherwise have occurred.  If, according to this view, we could commit the government to reducing its deficits—and, in some versions of the theory, to absolutely shrinking the size of the government—then the business sector would more than make up for the lost government-supported spending, thus launching the economy onto a new path of prosperity.

There is nothing in that theory that requires “magical” thinking.  Or put another way, one can believe the theory without having to deny the laws of mathematics.  It is ultimately an empirical matter to determine whether the “business confidence” explanation provides a better path forward than the standard approach to understanding the economy (which is also known as Keynesian economics).

As it happens, however, the evidence is completely one-sided, and the Keynesian approach clearly wins all of the empirical tests.  Even so, last year, one widely touted study claimed to find multiple examples of countries that reduced their deficits and then experienced economic growth.  Only one of those examples, however, involved a country that was experiencing a recession at the time, and that country (Ireland in the late 1980’s) relied heavily on export growth—an option that is not available to the United States today.

Other evidence also supports the conclusion that government spending cuts and tax increases—that is, deficit reduction measures—harm an economy, rather than helping it.  Britain, under its new Tory-led government, engaged in a radical program of cuts in government programs last year, and its economy is reeling from the effects.  Even Germany, the strongest economy in Europe, saw growth slow in 2008–10 due to its obsessive anti-deficit policies—but the slowdown was less painful there, because strong labor laws and active unions prevented the economic weakness from resulting in the kind of crisis-level unemployment seen in the United States and elsewhere.

The evidence is so weak for the anti-Keynesian theory, in fact, that economists like Joseph Stiglitz and Paul Krugman refer to the alternative theory as “believing in the Confidence Fairy.”  They—and I—concede that it would not literally be impossible for business confidence to drive an economy forward.  But we point to the fact that the evidence in favor of that view is so weak that it would require a huge leap of faith to imagine that everything has somehow now become different enough that the Confidence Fairy will save the day.

How Did the Political Conversation Become So Skewed?

A reader might well ask, however, how an entire political culture could possibly go so badly off the tracks.  If the economic evidence for deficit reduction as a solution to recession is so weak, that reader might ask, why do so many people think that deficit reduction is the way back from the economic abyss?

Part of the answer lies in the difference between long-run and short-run economic analysis, combined with a worry among economists about sending mixed signals.

In the short run, the best response to the current economic crisis would be to increase the deficit—by spending money and giving tax breaks to those who would be most likely to spend all of the money that they had received.  Yet there is a projected long-run problem with budget deficits.  This problem is not, as some claim, caused by an ever-expanding government; it exists for one simple reason: health-care costs.  Even if we cut the rest of the government down to a size not seen since the 19th century (abandoning all government support for things like food safety, environmental protection, roads, and so on), the increased costs of health care would, alone, wipe out all of those savings and more.

There is a further wrinkle as well, and it is quite important.  Even though there is a projected long-term deficit problem, it would still not be appropriate to aim for a balanced budget (much less to try to pay down the national debt, even on a long-term basis).  This is because the federal government always has available to it investments in long-term projects—such as early-childhood nutrition, education programs, and many infrastructure projects—that produce such a high rate of return that it makes sense to finance those projects with borrowed funds.  Some of my recent scholarly work has focused on exactly this problem, noting that our political process is not, as many people claim, skewed toward excessive deficits, but rather against long-term public investment spending.

Many economists say—not as a matter of economic theory, but as a matter of political calculation (in which they have no training)—that it is too dangerous to tell politicians and the public the truth.  We should not, these economists say, tell the American people that the deficit should go up in the short run, because the public might then think that deficits are good all the time.

Similarly, these economists suggest that we should not admit that non-medical spending cuts will fail to solve the long-run budget problem, because it is better at least to do something toward reducing long-run deficits, even if those cuts are devastating to important government services, and even if such cuts will ultimately not prevent a crisis.  Nor, this thinking continues, should we confuse people by saying that some long-term deficits (those that finance worthy public investments of the type I described above) are good, while others are bad.

The idea, I suspect, is that the political establishment and the public are likely to respond to any nuanced economic advice by throwing up their hands in frustration.  Just as people become confused about nutritional announcements—“Is salt good for us now, or bad for us?”—it might be harmful to the public’s confidence in economists if we seem to send mixed signals.  After all, President Truman famously begged for a “one-armed economist,” because he was so tired of having his economic advisors answer his questions by saying: “On the one hand . . . ; but on the other hand.”

Careerism and Fear-Mongering

Although it is understandable that economists might worry about the public’s ability to accept and process any advice that is not simplistic, we now have more than enough evidence to conclude decisively that the simplistic story we have been telling the public is doing real damage.  We have avoided confusion, but at the cost of a public debate that is based on gross falsehoods about spending and deficits.

Once economists decided not to admit (or, at least, not to speak readily about) the truth about budget deficits, it became all too easy for politicians of both parties to grab the simplistic slogan of “balancing the budget” as a cure-all for the economy—even in the face of the worst economic downturn since the Great Depression.  Even Democrats (and some Republicans) who knew better no longer dared—especially after Bill Clinton’s embrace of balanced-budget orthodoxy in 1995—to speak the truth about deficits.

With the political establishment uniformly committed to the idea that deficits are bad, economists and other qualified analysts knew that saying anything that cut against the conventional wisdom was simply a path to being ignored and marginalized in the debate.  Better to tell the politicians what they want to hear, in the hope that it will be possible to make some differences within the confines of thinkable thought.

This need not, moreover, be a matter of mere cynicism.  Again, there really are some scary trends in the long-term budget forecasts, and reasonable scholars acting in good faith could imagine that it is necessary to issue a call to arms, rousing the public into action to change those trends before they turn into disasters.

The accepted wisdom became so monolithic that many scholars even began to include anti-deficit discussions in papers that were not even focused on the topic of budget deficits in the first place.  I have asked some of my colleagues why—given that they know better—they are reinforcing the destructive, simplistic anti-deficit narrative.  Some have told me quite bluntly that they do so because they know that editors of journals are likely to publish articles that reflect the accepted anti-deficit mantra.  It is just good marketing, I was told, to push even an irrelevant anti-deficit message within a paper.

In the last few years, therefore, we have seen a growing number of scholars in economics and law using extreme language to describe the potential negative consequences of budget deficits.  Entire conferences were given names like “Desperately Seeking Revenue,” and used phrases like “train wreck” to describe the worst-case scenarios.

In just one scholarly paper that I reviewed earlier this year, the authors described long-term budget deficits as “a looming U.S. fiscal apocalypse,” a “fiscal catastrophe,” and “a massive budget crisis likely to result in another great depression.”  Others regularly invoke “fiscal Armageddon” and “nightmare scenarios,” and talk about the economy going “off a cliff.”

In sum, it can sometimes seem as if economists spend their time combing through thesauruses, looking for still more over-the-top descriptions of the possible long-term consequences of deficits.

Maybe a Little Honesty Would Do Us All Some Good

Perhaps the most revealing instance of a scholar admitting to a strategy of sowing fear came when one economist said, at an academic conference: “We gotta scare people.”  While he was attempting to make a joke (always a risky prospect for economists), he was not kidding.  Indeed, he also talked sincerely about the need to “frighten” the public into taking action.

The strategy of some economists, therefore, was to get people to do something by scaring them to death.  As a former President might say: Mission accomplished!  We have scared people so profoundly that it is no longer possible to say anything about budget deficits other than “Be afraid, be very afraid.”  Politicians, with their fingers on the pulse of a scared and worried public, have decided that deficits and spending can be blamed for everything.

Although recent polls indicate that the public’s presumed aversion to tax increases is nowhere near as strong as politicians imagine, being against deficits has come to mean being against spending, and ultimately being against having virtually any government at all.  While such a stance has long been preferred by a small fringe of the American public and some Washington lobbying groups, the “scare the public” strategy has led to a mass delusion that spending cuts are the answer to all of our ills.

The truth is very different:  Not only will spending cuts not cure our ills, but they will make the recession longer and deeper, and the indiscriminate cuts in long-term investments (especially, investments in education) will impoverish our future.

In sum, the decision by economists and others to dumb down public discussion about government spending and deficits—no matter how initially well-intentioned that decision may have been—has finally borne its rotten fruit.  An understandably fearful and confused public reaches for simple answers, stampeding in exactly the wrong direction.

If economists and politicians will not change course, and admit that government spending and deficits are important elements in our immediate and future prosperity, then we will continue to see political debacles like the one that ended with such a damaging outcome earlier this week.