The Austerity Debate Continues

This morning’s Financial Times is a must read.

It contains an excellent point/counter-point about the austerity argument now raging. The pro-growth argument is spelled out by Brad DeLong, while the austerity point of view is argued by Niall Ferguson. In this discussion DeLong is wearing the white hat.

Ferguson’s use of numbers is flat out dumb for the following reason: he mixes up trends and fails to realize that ratios move for more than one reason. His basic point is that there was a surge in the ratio of debt to GDP during the Great Depression, and that it resulted from FDR’s use of debt as economic stimulus. He goes on to argue that it was only the onset of world war that enabled the US to absorb that debt. Without a wartime economy, during which most ‘normal’ rules are abandoned, the debt ratio overhang would have undermined the enormous boom of the 1950’s and 1960’s. His major conclusion is that Keynesians ignore this debt ratio problem because they overlook the impact of the war. Conversely: take away the war and Keynesian economics would have ruined the economy.

Tosh. Bad, bad analysis.

The problem with this is that the true onset of deterioration in the debt to GDP ratio came during the Hoover years. During years of austerity. The ratio scarcely moved during FDR’s administration.

How can this be?

Because, even though Hoover was slashing the budget, the GDP was shrinking even faster. That drove the ratio of debt to GDP up even though little debt was being added. Ratios have more than one way of moving! It was not the enormous debt piled up by FDR that caused the ratio to grow, but the massive slump in GDP during the Hoover years. Once the economy started to grow again, from 1934 on, the ratio held firm. The vast majority of the increase in the debt to GDP ratio had occurred by 1933, the year FDR took office.

Duh.

Yes, the wartime economy was the final event that ended the possibility of further depression. But to argue that deficit spending undermined the debt to GDP ratio and therefore represented an existential threat to the economy is just bogus reasoning and a misreading of the facts.

A better reading of those same facts is that the deficit spending drove a recovery in demand sufficient to stall the continued growth in the debt to GDP burden even while debt was being added at historic rates. So the stimulus created a self-limiting debt burden: the added growth generated enough activity to allow the debt to be financed and eventually paid down.

In contrast the Hoover attempt at limiting debt was self defeating: by crushing demand it reduced GDP enough to produce a higher debt burden – as expressed in the ratio of debt to GDP – even as the deficit was cut. In other words austerity made the debt worse, not better.

In a nutshell that’s what I fear today. Austerity may well reduce GDP rather than boost it. A reduced economy implies that the existing debt weighs more not less heavily on future taxpayers.

We need growth, not austerity. Growth will cure the ratio ills that people like Ferguson are getting panicked about. Without growth austerity will make things a whole lot worse.