Is Austerity Worse Than Default?

For the U.S., budget cuts provide little benefit in the short run and could kill the recovery if too aggressive

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The U.S. has a debt problem. The borrowing path the nation has been on over the past several years is unsustainable, and Republicans in Congress seek to change that by cutting spending as part of a compromise to increase the debt ceiling. But the U.S. also has an economic problem. Still struggling to recover from a deep recession, growth has resumed at a modest pace, but the recovery has been slow and uneven. With the economy so fragile, would deep, immediate budget cuts be even worse than a default?

Most of Wall Street, the public, and Washington all agree that default would be a very serious problem. They're right: at best, U.S. borrowing costs would increase considerably, which would put further pressure on federal budgets. That would make deficit reduction even harder. But Ethan Harris, North American economist at Bank of America Merrill Lynch, thinks that -- as bad as this sounds -- deep spending cuts would be even more harmful to the nation.

Austerity Isn't Pretty

Let's take a step back before considering Harris's argument. Austerity can have its benefits in the short-term, but chiefly when a nation suffers from very high debt costs, as investors fear that nation could reasonably default. In this case, investors will take austerity measures as great news that a nation is serious about its fiscal path. Their fears of default will dissipate and the nation's debt costs will fall.

But if a nation enjoys low borrowing costs, then austerity has no short-term benefits. In that case, either taxes would increase, spending would decline, or both. In all of those scenarios, there would be less money in the economy that can be used for expansion and growth. Instead, it would go towards paying down the nation's debt.

This describes the situation in the U.S. Borrowing costs are already low and are expected to remain low if the U.S. raises its debt ceiling and pacifies investors by putting in place a long-term deficit reduction plan. As a result, strict austerity measures in the short-term would provide no benefit.

Even if the government is inept at spending taxpayer money wisely, withdrawing money from the economy to pay down debt will cause harm. Remember, there's no accompanying tax break so that the private sector can use that money more wisely -- it's just going to deficit reduction, for which there's no benefit if you've already got low borrowing costs.

But Worse Than Default?

And that's where Harris's fears come in. Steve Goldstein at Real Time Economics reports:

He points out that even if Congress takes no action, programs comprising more than a percentage point of gross domestic product are due to expire next year, and that the debate about austerity can hurt even before the cuts kick in.

"The risk of a bad outcome is high," he said. "We are not sure whether it is worse to do nothing, and temporarily default on the debt, or to do too much and enact big front-loaded deficit cuts."

Harris said the best policy outcome would be modest upfront spending cuts with a commitment to deal with long-run structural deficit concerns after the 2012 presidential election.

Harris's point here is important to consider: austerity measures could threaten the prospect of recovery. But so could default. The problem with a default is that nobody knows what it would look like. Would investors demand a much higher yield on U.S. debt going forward? How high, and for how long? Or would they flee U.S. debt entirely? Would the dollar's status as a global reserve currency be affected? For all we know, the damage could be in excess of even a percentage point of GDP.

Easy Problems to Solve

The good news is that the nation doesn't really have to confront any of these awful outcomes. It's within Washington's power to do the right thing here, and that differs from Harris's preferred policy outcome slightly. To be sure, the debt ceiling must be raised. But some long-term -- not short-term -- deficit reduction measures must be included. They need to be significantly back-loaded, however, so that the economy will be strong enough by the time they hit to sustain their impact.

Although Harris doesn't appear to think such long-term deficit reductions are necessary at this time, it's puzzling why. The U.S.'s debt path is clearly on a dangerous trajectory. If Congress punts to a future administration, investors should rightly become warier about U.S. debt. If they do, then borrowing costs will begin to rise and paying down the debt will be even harder. A well-structured, prudent long-term plan is the best solution here, to accompany a resolution lifting the debt ceiling in the meantime.

Image Credit: REUTERS/Jim Bourg