David Coates

The Inmates and the Asylum: The Madness of Cutting Deficits in the Depth of a Recession

(co-authored with Donald Frey)

You might think, might you not, that policy-makers and those advising them are intelligent and caring human beings? Well, we are beginning to wonder whether in fact they are. We are beginning to wonder whether the intelligent ones really care, or if those who care are really intelligent.


Because all the talk these days is of deficit reduction: deficit reduction in the middle of the worst recession for more than six decades!

Cutting federal and state budgets is fast becoming the new Holy Grail. Republicans and blue-dog Democrats alike are insisting that budgets in the public sector be cut, as though it was public sector largesse, rather than private sector irresponsibility, that created the current recession.

  • They advocate cutting budgets in the public sector when unemployment in the private sector is still stubbornly stuck (officially around the ten percent mark, more likely in reality nearer the twenty percent), and when that cutting is likely to generate a new round of lay-offs – this time among teachers, fire fighters and law enforcement officers.
  • They advocate cutting budgets when the evidence is already clear from economies in which sharp deficit reduction is currently underway – the United Kingdom in particular – that a “slash and burn” approach to public spending not only undermines long-term economic growth by hitting key education and training budgets. It also deepens the recession it is supposed to alleviate – to the tune in the UK’s case of an additional 1.3 million jobs to be lost over a five-year period, on the UK Treasury’s own estimates![1]
  • And while still advocating the extension of the Bush tax cuts for the wealthiest Americans, the Republican Party leadership has continued to oppose the extension of unemployment insurance to the long-term jobless.[2] Indeed some conservative commentators have even argued that with unemployment insurance “there will be less work and more unemployment”.[3]

Given the scale of involuntary unemployment now before us, and the prevalence of official warnings of only slow economic recovery to come,[4] this way of arguing is madness masquerading as sense.

Actually it is more than madness.

It is a clear case of conservative forces using a recession that was caused by lack of government regulation to cut back the role of government still further.

It is a clear case of right-wing commentators resurrecting the hoary old falsehood that even states as large as ours have no choice but to subordinate economic policy to the requirements of capital markets.

It is a clear case of the inmates once more trying to take over the asylum – which is why progressives need continually to stress the liberal alternative: no welfare-focused budget cuts now.

How to make the anti-cutting case? By emphasizing the following.

l. Excessive government spending did not cause the current recession. The current recession was caused by recklessness, folly and greed not in publicly-owned/run agencies but in privately-owned and lightly regulated financial institutions.[5] That should not have come as a surprise because, after all, we have already seen the consequences of such folly at least once before: the Reagan era of deregulation culminated in a Savings and Loans crisis that in so many important ways foreshadowed the crisis of 2007-9.  Twenty years ago, the S&L crisis was resolved only by federal spending; and again in 2008 federal spending was part of the solution, not part of the problem. In 2008-9 it was only federal spending (first TARP, then the stimulus package) that prevented the recession from becoming even deeper. The federal deficit is now so large not because government spending is somehow out of control, but because the scale of recession that bank folly created required an injection of public funds of just such an unprecedented scale. The banks threw a party and left a mess. The government picked up the tab for the cleanup. For some reason now all the talk is about the tab, not the party. It simply makes no sense.

2. That banks should now be worrying about the credit ratings of the U.S. government at some future date is the ultimate example of a double standard. They had no such worries about credit quality when they filled their own portfolios with purely speculative derivatives and sub-prime mortgages. Apparently fiscal “righteousness” can be ignored for banks, but not for goverments, and for those who depend on government in hard times—small businesses, teachers facing layoffs, and the unemployed. Cutting budgets and hitting the poor is pure class politics masquerading as economic imperative. We need to call it for what it is – the latest example of Wall Street’s short-term interests trumping the long-term needs of Main Street. That we should tolerate a new bankers’ ramp after what the banks have just done to us simply makes no sense.

3. For good measure, let us also remember that household budgets and government budgets are not the same thing. Although many households borrow to spend beyond their current incomes, they eventually must repay. Households face zero-sum limits. Public budgets are entirely different: there are no automatic zero-sum limits there.[6] For as governments overspend in times of recession, that spending generates jobs, incomes and ultimately rising tax revenues. In recessions, governments can go a long way to spending their way out of deficits in a manner that families cannot. Public spending in a time of recession does not squeeze out either private sector employment or investment, because private sector spending automatically drops in hard times – indeed it is the most immediate cause of recessions. Rather, government spending creates demand both for goods and for jobs; [7] and as it does so, the initial ticket-price put on the government spending invariably falls.

4. George W. Bush’s TARP, for example did not cost its initial price tag of $700 billion. TARP administrators did not even spend $700 billion. As of May, the U.S. Treasury, after receiving repayments, listed the cost of TARP at $105 billion, and that number is likely to fall again with further repayments. $105 billion is roughly equivalent to a mere 50 or 60 days spending by the Pentagon. We live with this scale of Pentagon spending to fight enemies abroad. So why not live with an equivalent scale of spending to fight economic collapse at home? And in any case, TARP was not the key government stimulus program in play after the 2008-9 financial melt-down. That accolade more properly belongs to the later American Reinvestment and Recovery Act which injected about $800 billion dollars into the U.S. economy over two years. When judging its impact, we do well to remember that because of Republican opposition, that stimulus was kept too small. Given that U.S. GDP is about $14 trillion, it is clear that this act spent the equivalent of only about 6% of GDP overall, or a mere 3% per year. Further, due to Congressional Republicans, about one third of the ARRA was given over to tax cuts, which do not stimulate economic growth and job recovery as effectively as direct government spending.[8] Yet despite the smallness of the ARRA stimulus, the rapidly collapsing economy did stabilize once the act went into effect; and compared to the deficits which a deeper collapse could have produced, the stimulus surely cost less overall than its initial $800 billion price-tag. Indeed, given the likelihood that a larger stimulus would have produced a more rapid turnaround, it challenges credulity that those who resisted the stimulus bill should now point to the weakness of the recovery as a sign that stimulus doesn’t work. There is only so much sophistry that an economically insecure electorate should be required to absorb!

5. The case for deficit spending rather than deficit reduction is particularly strong now. The current record-low interest rates for U.S. bonds suggest that this is precisely the moment for the government to be borrowing (to spend more) because low rates are due to excess funds looking to be put to work in a recession when business does not want to borrow. At present, financial markets seem hungry for more U.S. bonds. Even if it were not so, however, the U.S. need not be hostage to the international capitalist credit markets: the central bank can always buy up the bonds, thus keeping them out of private hands and also increasing “quantitative easing.” As a variation on this tactic, the Federal Reserve could even trade for Treasury bonds the private securities it purchased during the crisis. (The monetarist dogma against the massive outright purchase of government bonds by the central bank is that increasing the monetary base is inflationary – the fallacy of this claim is seen in the fact that deflation is a more likely threat at present.) An additional possibility rarely noted by fiscal conservatives is that a government issuing a lot of debt when interest rate are low might also buy it back on the open market at less than face value when interest rates rise (depressing bond prices). Thus, spending a dollar in recession, when needed, could actually cost less than a dollar if the government decided to retire debt by running a surplus in better times.

6. U.S national accounting practices consistently exaggerate “deficits” compared to what they would be in corporate accounting. Corporate spending on investment projects does not show up in corporate operating budgets — capital spending is distinct; yet government capital spending on national investments is run through the operating budget, thus showing up as a deficit. In addition, debts are often offset by assets which show on private balance sheets, whereas fiscal conservatives ignore government assets (think, for example, of the strategic petroleum reserve). It has become popular to state the national debt as a percentage of the GDP, yet right now the national debt to GDP ratio is far lower than the average homeowner’s mortgage to income ratio.

The U.S. economy may have a long-term public debt problem. That remains a matter of some controversy. But what ought to be less controversial is this: we will not generate the sustained economic growth that alone can ease that long-term debt issue by plunging the contemporary economy into a double-dip recession now; and a double-dip is what we will get if the UK’s “slash and burn” approach to deficit reduction is reproduced here.[9]

Dealing with deficits is always a matter of political will, never one of economic law.  We should worry less about the consequences of not cutting deficits than about the casualties likely to be caused by cutting them, because those casualties are real Americans losing real jobs, real homes and real opportunities. Trading paper deficits for real people – the best social contract we can strike at the moment. Oh that Washington DC saw it that way!

[1] http://www.guardian.co.uk/uk/2010/jun/29/budget-job-losses-unemployment-austerity

[2] Senator Kyl is a case in point. He appeared on Fox News Sunday (July 11, 2010) putting the case for the extension of the tax cuts. Steven Benen of Washington Monthly reported it this way: “It’s quite a message to Americans: Republicans believe $30 billion for unemployment benefits doesn’t deserve a vote because the money would be added to the deficit, but Republicans also believe that adding the cost of $678 billion in tax cuts for the wealthy to the deficit is just fine.” (cited in Sam Stein, “Jon Kyl: Extend Bush Tax Cuts For Wealthy Even If They Add To Deficit”, posted on The Huffington Post July 12, 2010: accessible  at http://www.huffingtonpost.com/2010/07/12/jon-kyl-extend-bush-tax-c_n_642862.html?utm_source=DailyBrief&utm_campaign=071210&utm_medium=email&utm_content=NewsEntry

[3] Arthur B. Laffer, “Unemployment Benefits Aren’t Stimulus”, The Wall Street Journal, July 8, 2010. Laffer wrote this. “While the unemployed may spend more as a result of higher unemployment benefits, those people from whom the resources are taken will spend less. In an economy, the income effects from a transfer payment always sum to zero….But it doesn’t stop there. While the income effects sum to zero, the substitution effects aggregate.  The person from whom the unemployment funds are taken will find work less rewarding and will work less. The person who is given the unemployment benefits will also find work relatively less rewarding and will therefore work less. Both people in this two-person economy will be incentivized to work less.”

[4] For the latest OECD forecast on the relationship between UK budget cuts and rising joblessness, see http://www.guardian.co.uk/business/2010/jul/07/oecd-concerned-unemployment-jobs-programmes

For the latest IMF World Economic Outlook, mixing confidence on growth with worries over its longevity and strength, see http://www.imf.org/external/pubs/ft/weo/2010/01/index.htm

[5] For the equivalent case in the UK, see Philip Inman, ‘Private speculation rather than public profligacy is real villain of Labour years”, The Guardian, July 5, 2010

[6] This is why the often drawn parallel between family budgets and government budgets is so misleading. (The President himself slipped into that error during the 2009 State of the Union Address. For the argument, see https://www.davidcoates.net/2010/01/31/framing-errors-in-the-state-of-the-union-address/).

[7] This is where our disagreement with people like Arthur Laffer is at its sharpest. In the WSJ piece already cited you will find this. “Imagine an economy that produces 100 apples. If 10 of those apples are given to the unemployed, then people who would otherwise have had those 10 apples now won’t. The stimulus of 10 apples for the unemployed is exactly offset by the destimulus of 10 apples for those people from whom the 10 apples were taken.” Our point back is that, without the stimulus of government spending, at least 2 of those apples would probably have rotted on the tree for want of anyone to buy them. Indeed, in the depth of the bank crisis of 2008, if economic recovery had been left to market forces alone, all 10 apples may well have been lost. Unsold apples rot. They rot immediately. Unemployed people suffer. They suffer in the here and now. In the long-term the demand and supply of labor may all come together in an elegant equilibrium if both product and labor markets are left unregulated, but what use is that for those without work now? Long-term economic solutions may look attractive in the textbook, but in the world they purport to describe they have less appeal: for as Lord Keynes once famously said, in the long-run we are all dead!

[8] “A government dollar spent on food stamps ends up generating $1.73 of extra demand in the economy; on unemployment benefits $1.64; on infrastructure $1.59; and on aid to states $1.36. They also tell us, by contrast, that making the Bush tax cuts permanent would add only 29 cents for every dollar surrendered, that a cut in corporation tax yields only 30 cents for each dollar, and that making dividend and capital gains tax cuts permanent yields only 37 cents for each dollar.” (David Coates, Answering Back, New York: Continuum Books, 2010, p. 262 – citing Mark Zandi’s widely respected calculation of how to get the results from different forms of public policy) For a recent use of this data to report on the plight of the U.S. jobless, see Paul Wiseman, “Long-term jobless fear loss of benefits”, USA Today, July 15, 2010, pp. 27-8.

[9] For Paul Krugman’s equivalent argument, see his “Now and Later” piece in The New York Times, June 21, 2010; or his “Myths of Austerity”, The New York Times, July 1, 2010. For Robert Creamer’s equivalent argument, see his “Progressives and the Deficit”, posted May 11, 2010 on The Huffington Post at http://www.huffingtonpost.com/robert-creamer/progressives-and-the-defi_b_571347.html

Donald E. Frey is Professor of Economics, Wake Forest University

David Coates holds the Worrell Chair in Anglo-American Studies at Wake Forest University. He is the author of Answering Back: Liberal Responses to Conservative Arguments, New York: Continuum Books, 2010.

He writes here in a personal capacity.

14 Responses to “The Inmates and the Asylum: The Madness of Cutting Deficits in the Depth of a Recession”

  1. Maxine Udall says:

    “Oh that Washington DC saw it that way!”

    Unfortunately, their campaign contributions and their future incomes when they leave public “service” depend on them not seeing it that way.

  2. Peter Bondy says:

    David Coates and Donald Frey present a powerful and interesting posit for more spending rather than budget cutting by federal and state entities.

    The unemployment rate, as they point out, is far in excess of officially published numbers. It is time that methodology be changed to produce a more realistic and meaningful answer.

    The impact of excesses with subprime mortgage derviative securities and other credit backed paper is as they indicate at the core of the problem – excessive abuse by certain financial institutions. Having concluded, more than 15 years ago, that CMO’s, mortgage backed securities, were not appropriate as investments for immediate annuity reserves, I have remained incredolous of the freedom with which these derivative securities have since been acquired to back monies belonging to others and I have remained incredulous of the argument made by rating agencies in assigning AAA ratings to funds backed by these. Mud pie with icing on it, after all, is still mud pie.

    We are in a very difficult time. Thanks for a timely thought provoking article.


  3. Barry Clendenin says:

    As one of those former advisors to the policy-makers mention in the excellent analysis prepared by Professor Frey and Professor Coates, I believe they have clearly stated the quandry facing the Congress, the Administration and especially incoming OMB Director Jack Lew. In recent memory, the Reagan Administration and the Clinton Administration faced similar — if not as severe — economic and budget challenges and found ways to overcome them both through tax and spending cuts, as well as tax and spending increases. We can do both.

    I agree with the concerns about short-term problems faced by our fellow citizens; but looking a few years beyond 2010, citizens, business leaders, academic leaders and politicians will also need to exhibit some courage to deliver the bad news that at least from the federal side, we may have over promised what we can reasonably finance.

    Thanks for the opportunity to comment.

    Best regards.

  4. Brandon says:

    Spot on. The consistent “sacrifice” made along class lines by many Republicans is disgusting. Truly an extra sofa has been given precedence over a man’s ability to feed his family.

  5. Thomas Paine says:


    I submit that madness is continuing to pile on a national debt that threatens the very future of our democracy and our nation. The waste, fraud, featherbedding, pork, incompetence, and habitual dependence on debt has done little for our country, save for the enrichment of the ruling class.

    It’s high time that the unfettered spending be drastically curtailed. A painful period of recession will certainly follow, but that limited duration pain is a far better consequence than the certain systemic failure that awaits us and future generations should we follow the course you recommend.

    Keynesian economics has had its day — it has in fact driven us to this brink of financial disaster. I find it irresponsible to continue blindly advocating its continued use as a salve to nations already dragged down by debt. Greece, anyone?

  6. goatherd says:

    I heard you on Mike Collins’ show this morning and enjoyed the conversation a lot. I look forward to reading your blog regularly. I actually am a goatherd, so I don’t pretend to understand economics. But the illustration Mr. Laffer gives regarding the “100 apple economy” is a deceptive analogy, not just a poor one.

    Unemployment benefits are given in money, which is a medium of exchange, it is not consumable in itself, like an apple, but must be traded for other products which are. A market is sustained and invigorated by the number and frequency of exchanges. So, the benefit of injecting money into the economy is distributed each time that money is used in an exchange and the economy is strengthened overall because the volume or number of exchanges is increased.

    What Mr. Laffer describes is essentially an economy without a market, because he leaves out the necessity for exchange. As a farmer I could easily describe his analogy in simpler terms.

  7. Susan Nicole says:

    How convenient that all the footnoted sources are liberal like the author himself!

  8. The Looming Battle over Social Security | David Coates says:

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  12. Odell Bring says:

    Thanks , I have just been searching for info approximately this subject for ages and yours is the best I’ve found out so far. However, what about the conclusion? Are you positive concerning the source?

  13. David Coates says:

    Odell, I’m not sure I understand the question. Don and I certainly stand by the argument. Do say if there is some other information you need
    Best wishes

  14. David Coates: The Fiscal Cliff, the Republicans and the Ghost of Christmas Past | Political Ration says:

    […] Co-authored with Don Frey […]

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