Austerity as Insurance?, Frum’s Question and Debt Deflation

Megan McArdle argues that those in favor of more stimulus in the short term with reduced budget deficits in the medium and long term are similar to corporate executives at BP not installing remote control valves and other safety mechanisms:

Austerity is an expensive form of insurance against a true fiscal crisis. And though it doesn’t necessarily seem like it when you’re not having one, fiscal crises are much, much worse than austerity budgets. Fiscal crisis means that rather than unpleasant cuts, you have sudden, unmanageable collapses in things like public pension plans. The resulting suffering is not unpleasant; it is disastrous.

A year or two ago, I’m sure some corporate executive at BP was asking why the company would consider installing expensive remote control valves on its offshore rigs, when this sort of spill is extremely rare, and the fail-safe might not even work. One could even argue that given the economic cost of higher gasoline prices, and the rarity of these spills, BP made a good bet. We might well . . . if the spill hadn’t happened.

I’m not sure on that BP thing, but there’s an argument that austerity gives us some breathing room and takes some pressure off our deficit as a hedge.

One thing I want the Austerians to understand is that austerity right now would be counterproductive to their stated goals. Forget the unemployed, who in the austerian mind are probably, in Casey Mulligan’s famous phrasing, “making this the year they coach junior’s baseball team” instead of getting a job. Forget aggregate demand and unused capacity and interest rates and a complete lack of crowding out and low-hanging fruit.

The risk here for cutting the budget in the short-term is that this would increase the deficit. At a baseline, there’s a real risk it could be counter-productive; we cut the deficit, growth slows, tax income declines, and we are right back where we started. This is the experience of Japan in the 1990s. Look at the marked “fiscal reforms” and their effect:

We can’t belt-tighten out of this recession. And the real thing we need to insure against is a decade of double-dips and deflation, leaving us in terrible shape to handle any type of medium or long term problem.

Frum’s Question

Two important columns worth your time. David Frum asks, in relation to the short-term deficit question and stalling growth:

But if Krugman’s direct government expenditure is not a very good policy answer, his dire economic warning remains a haunting policy question. What can we do to accelerate economic growth and job creation? For those of us on the free-market side of the debate, the question is even more haunting: What’s our countervailing idea? And if our countervailing idea is tax cuts, what is our reply to the obvious rebuttal that the Bush tax cuts have been in effect through the whole of this crisis, seemingly without effect?

What is the “free-market” answer here? In his reply to Frum’s column Roosevelt Institute’s Marshall Auerback gives the haunting answer:

Let’s be clear: The “free market solution”, to use Frum’s terminology, is basically deflation. If households attempt to net save by spending less than they are earning, and businesses attempt to net save (reinvesting less than their retained earnings), then nominal incomes and real output will be likely to fall. Money incomes and economic activity will tend to contract until private savings preferences are reduced (with essential goods and services taking up a larger share of household income as incomes fall), or until depreciation leaves businesses and households inclined to invest once again in durable assets. In the absence of any countervailing fiscal stimulus, common sense suggests that a drop in private income flows while private debt loads are high is an invitation to debt defaults and widespread insolvencies — that is, unless creditors are generously willing to renegotiate existing debt contracts en masse.

Now, I suspect that some of Frum’s fellow conservatives actually think this sort “cleansing” is good. They believe it on both moral and economic grounds. Maybe not all, but a number of the more extreme libertarians with whom I occasionally debate, actually embrace this argument. Fair enough. It’s not something I would advocate, but it has the virtue of being ideologically consistent with many of the tenets of a free market/libertarian orientation….

the consequences of embracing this extreme form of “austerianism” right now would be very unpleasant.
But Frum is right: if this is the optimal free market position, conservatives who embrace it ought to be honest enough to express it in the political arena and debate it openly. No more of these secret committees meeting with little or no public scrutiny (The Commission on Deficit Reduction is Exhibit A in this regard). And no more hypocritical lectures from Wall Street investment bankers, the crony capitalist welfare queens par excellence.

I’ve heard this from some I know as well. I’m reminded of the current macro graduate student I know, very much into the dark ages macro, who was upset that when he was a teaching assistant for an intro macro class he couldn’t cross out “The Great Depression” on the blackboard and replace it with “The Great Vacation” and “tell the kids the truth.”

I also place it with a lot of the new intellectual and activist energy on the Right forming around things like the Mises Institute, Murray Rothbard, and Ron Paul “End The Fed” (which is how I read the Tea Party movement). Ron Paul is so popular on campuses poor Josh Barro had to write a piece for the National Review explaining why “End The Fed” shouldn’t be a policy plank of a resurgent conservative movement. (He sadly doesn’t address one of the core of their problem with the Fed, the illegitimacy of a fractional reserve banking. Heh.)

Not everyone on the Right is this way. Scott Sumner says “The other 98 years I am a Chicago-trained, libertarian, inflation-hawk. Twice a century I put on my Irving Fisher super-hero suit, and emerge from my deep underground bunker.” If only he could assemble a Justice League for this Crisis. Because I’m afraid this debt-deflation mindset is where a lot of the country is, and it is exactly the cliff our country is driving towards.

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3 Responses to Austerity as Insurance?, Frum’s Question and Debt Deflation

  1. Jay says:


    Nicely put.

    I think the economists forgot that our economic policy is more political than economic and for that reason and no other can remain in this gravity free logic free zone of weirdness.

    Keep up the good work.


  2. Thorstein Veblen says:

    I’d probably say that $100 billion in additional stimulus would increase the size of the economy by about $200-300 billion, in which case roughly $50-75 billion would come back as taxes…

    So, stimulus spending probably doesn’t pay for itself, but damn is it cheap given that we can actually, you know, do useful things with it…

  3. I quite agree with this analysis. Especially when applied to the UK economy. I think the timing of the austerity packages maybe off. The consumer and business sector are both still deleveraging. The govt decreasing its contribution to the economy. Not sure where growth will come from.

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