As we approach sequestration today the dominant narrative continues to be that the huge run-up in the deficit since the Great Recession has been our greatest political—perhaps even a moral—failure. But it isn’t a failure. This is exactly how the system was designed to work if the economy ever saw a downturn on the scale of the 2008 financial crisis. The deficit is collapsing through the same planned process. As the economy recovers, it is falling quickly, down to 7 percent in 2012, and an estimated 5.3 percent in 2013.
These are our "automatic stabilizers" at play. Though it sounds vaguely hydrologic or like a bad steampunk creation, it’s straightforward: The economy will naturally suffer from periods of slack demand in which there isn't enough purchasing power in the economy to produce goods and employ all of our resources, including people. Automatic stabilizers then kick into motion in to counteract this.
One important automatic stabilizer is the tax code, which has people pay less in taxes if their incomes suddenly drop. Another is the network of programs that boost income, which include things like unemployment insurance and food stamps. People become increasingly eligible for them as they become unemployed or slip below the poverty line. This not only provides support for struggling citizens, but also gets money to people very likely to spend it, which boosts demand as the economy weakens.
As a result of these stabilizers kicking into gear, the government collects less in taxes and spends more money through social insurance. Both the revenue and expenditure sides of this contribute a larger deficit, and the deficit we’ve seen since the recession started in 2008 has been driven by these dynamics.
Automatic stabilizers have advantages over other ways policymakers try to manage the economy, such as monetary policy and targeted-spending programs. They are, well, automatic. So they don't need to go through Congress in order to go into effect, and they don't need to go through Congress to be turned off either. This is an example of Congress creating programs that work faster and smarter than it itself can. Even when they agree that action to boost demand is appropriate, liberals and conservatives who want to provide stimulus are often at odds; conservatives worry that more government spending will become permanent, and liberals worry that tax cuts will also become etched in stone. This can lead to stalemates even when the economy needs help, as we can see right now.
Another advantage of automatic stabilizers is that they are in place and ready to go, for those who are hit the hardest during recessions. Use of automatic stabilizers like unemployment insurance actually become a leading indicator for what is happening to the economy, as it is able to give us information other places lack.
We can see the effect of automatic stabilizers in the data. The Congressional Budget Office estimated that spending on automatic stabilizers went from 0.1 percent of GDP to 2.2 percent from 2008 to 2009, as the economy went into free fall. It peaked at 2.5 percent in 2010, is now down to 2.2 percent, and will approach zero as unemployment comes down.
These automatic stabilizers constitute a large part of the run-up in debt during the Great Recession, but they weren’t enough to try and push us back to full employment, or even a place where traditional Federal Reserve policy could be effective. Most of the remaining increase in the debt is from discretionary fiscal policy—things like the spending and tax cuts in the stimulus package, the payroll tax cut, and the extensions of unemployment insurance. These scaled up the spending that was necessary in order to keep the economy from collapsing. Not only was this appropriate, but interest rates collapsed as demand fell, so investing in infrastructure and basic research, programs included in the stimulus, have never been cheaper to fund. And rather than a permanent expansion of the government, these programs ended themselves too soon, well before the economy had reached an escape velocity.
It requires a large government to be able to pull this off. As the Economist Hyman Minsky noted in the 1980s, in a list of reasons why the Great Depression hasn't happened again, in 1929 the federal government was only 3 percent of GNP, so it wasn’t large enough to run a sufficient deficit capable of offsetting the collapse in investment that occurred during the Great Depression.
Right now we should be boosting our automatic stabilizers, both for our current crisis and future recessions. The policy of the past 30 years has been to trust the Federal Reserve to stabilize the economy, though the past several years have shown that the Fed works better in crisis mode when there is sufficient fiscal support. Sadly Republican policy has been to move as many programs as possible to the states, where there is less ability to provide stabilization in a crisis. And the sequestration will cut much of the spending that is holding the economy in place. The primary goal at this juncture should be to nurture the economy back to its potential with smart investments, which will largely take care of all our other budget issues, as it did in the 1990s. Focusing on self-imposed timeframes, debt levels, or crises is the wrong way to go.