Austerity Is Here to Stay
A collective shudder swept through financial markets and across official Washington late last month after Federal Reserve Chairman Ben S. Bernanke announced it soon will be time for the U.S. central bank to step away from a half-decade of stimulating the economy with trillions of dollars in easy money. As stock prices slumped and falling bond prices pushed interest rates to a two-year high, the financial world signaled little confidence that Congress and the White House would veer away from their determined course of fiscal contraction.
Especially for the past two years, the Fed has counterbalanced with its monetary stimulus the spending restraint and tax increases that lawmakers and President Barack Obama have embraced, propping up a fragile recovery while giving elected officials room to debate, and enact, a series of measures that add up to an American version of fiscal austerity.
It was inevitable that the Fed would reverse course — the threat that its lax policies would lead to a destabilizing degree of inflation was much too great. Yet, now that Bernanke is telling everyone that the economic landscape is changing, there’s no sign that lawmakers and executive branch officials are prepared to respond in kind by loosening fiscal policy to balance a tighter monetary environment. If anything, the course of fiscal constraint appears to be locked in.
Many economists fret that austerity Washington-style will put the brakes on more rapid economic improvement. If the U.S. recovery falters, that would seriously harm the global economy, and the result might be a second worldwide slump to rival the one that has only begun to show in the rearview mirror.
"The budgetary procedure that is in place in the United States, which leads to a budgetary adjustment, seems to us absolutely inappropriate," said Christine Lagarde, managing director of the International Monetary Fund, at an economics conference in France earlier this month. Lagarde’s comments are all the more notable because her organization had been preaching austerity, particularly for Europe, since the 2008 financial crisis. But the IMF is now clearly backpedaling, and last month it took aim at U.S. fiscal policy in a report that said "the deficit reduction in 2013 has been excessively rapid and ill-designed."
The federal deficit, more than any other measurement, tells the story of persistent fiscal constraint. The deficit is projected by the Congressional Budget Office to fall to $642 billion this year, a 41 percent one-year decline that will bring the annual shortfall to roughly half what it was just two years ago. The CBO says the deficit is likely to continue shrinking until it is a mere 2.1 percent of gross domestic product in fiscal 2015, after peaking at 10.1 percent in 2009.
This rapid shrinkage is the result of a mix of spending cuts, including the sequester that took effect in March, higher taxes that came with the fiscal-cliff agreement at the very start of this year and a clear strengthening in the economy — most pointedly in housing.
In the fiscal-cliff deal, Congress raised taxes by more than $600 billion over a decade, and no one is talking about cutting taxes below that level right now. Spending has been reduced by more than $2 trillion over a decade through the 2011 debt limit law, which established 10 years’ worth of discretionary spending caps and set in motion the automatic spending sequester.
And while Democrats would like to replace the $1 trillion sequester with revenue increases and alternative spending reductions, Obama and lawmakers from both chambers of Congress have essentially agreed — both in the laws that have been enacted and the budget plans that have been proposed — to continue on the current deficit-cutting path in the immediate years ahead.
House Speaker John A. Boehner, a critic of the Fed’s bond-buying program of "quantitative easing," welcomed Bernanke’s comments about winding it down. "I think it’s over the top and puts us in very dangerous territory," the Ohio Republican said in a recent CNBC interview. "We all knew this day was going to come when he was going to start to back up a little bit — better now than later."
The message was clear enough: The sharp differences between Republicans and Democrats over the specifics of fiscal policy preclude any agreement to change course.
"It looks to me like we’re sort of stuck in a gridlock situation right now," says William G. Gale, co-director of the Urban-Brookings Tax Policy Center and an economist on the White House Council of Economic Advisers in the early 1990s under President George Bush. "Even if we weren’t, I wouldn’t expect there to be more expansionary policy. The Republicans don’t want it because it suggests that government can be part of the solution, and for whatever reason, the Democrats are not asking for it," Gale says.
The Fed’s threat to begin withdrawing stimulus by ending its $85-billion-a-month bond-buying program adds a new dimension to the economic tableau. Many Democrats have supported the efforts of Bernanke, a Republican. But many GOP lawmakers called the Fed’s actions an "extraordinary intervention" in the economy that risks causing inflation and distorting economic activity.
Bernanke has defended the Fed’s actions — which have included holding the central bank’s benchmark interest rate at essentially zero since December 2008 — as an important support to the recovery. "Notably, keeping longer-term interest rates low has helped spark recovery in the housing market and led to increased sales and production of automobiles and other durable goods," Bernanke told the Senate Banking Committee in February. "By raising employment and household wealth, for example through higher home prices, these developments have in turn supported consumer sentiment and spending."
Now, it appears, Washington may be on track to find out how much the economy can grow while policy is intent on contraction.