Two years into austerity and counting…

It’s popular to criticize Keynesian economics by alleging that the Recovery Act was an experiment in fiscal expansion, and because two-and-a-half years later the economy still hasn’t roared back to life, it must have failed.

What this criticism forgets is that the federal government isn’t the only government setting fiscal policy. While the federal government did conduct Keynesian expansionary fiscal policy over the last few years, the states have been doing the reverse, acting, as Paul Krugman put it, like “50 Herbert Hoovers” as they cut budgets and raise taxes. They’re forced to do this because the cratering of private-sector spending which threw the economy into recession blew huge holes in their budgets (in particular with a huge fall in income, sales, and property taxes, and increases in demands on safety-net programs), and just about all of them are required to balance their budgets each year. Overall, states have had to close over $400 billion in shortfalls over the last few years – this is spending power siphoned off from the economy and acts as a significant “anti-stimulus.”

This means that just looking at the amount of federal stimulus that’s been enacted significantly overestimates how much fiscal support has actually been pumped into the economy. In fact, as the Goldman Sachs graph below shows, the net fiscal expansion across all levels of government only lasted through the third quarter of 2009. For the last two years, state and local cuts have been overwhelming the federal fiscal expansion, making overall fiscal policy across all levels of government actually contractionary and creating a net drag on economic growth.

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What’s needed to reverse this drag of public-sector austerity on growth? The $35 billion for state and local aid that’s part of the American Jobs Act is a good start, as it would help keep states and local governments from being forced to cut further. As the last two years of austerity have shown, this would only serve to further weaken the economy. And if we’re going to get out of this economic hole, we first need to stop digging down further.