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John Boehner's Premature Austerity

In a speech on Monday night, House Speaker John Boehner announced that the GOP will demand spending cuts that match or exceed any increase in the debt ceiling. However, Boehner gave few specifics:

Mr. Boehner didn't give a dollar amount in spending cuts he was aiming for, the time period in which to make the cuts or the amount the debt ceiling should be raised.
But this report on his speech from the NY Times gives an indication of the magnitude he has in mind:
"Without significant spending cuts and changes to the way we spend the American people's money, there will be no debt limit increase," Mr. Boehner told members of New York's business and finance community. "And cuts should be greater than the accompanying increase in debt authority the president is given." Mr. Boehner said those cuts should be in the trillions of dollars, not billions.
Trillions not billions. I don't think the actual amount will be anywhere near that large, but to illustrate how to use "back of the envelope" calculations to estimate the economic impact for a change of any size, suppose there are $600 billion in cuts over two years. What would be the macroeconomic impact of such a change?

Estimates of the multiplier vary, and the exact magnitude is controversial. Generally, the multiplier is thought to be larger than 1.0 in severe recessions, and much smaller, perhaps even zero, when the economy is near full employment. Assuming a multiplier of 1.0 -- a value I think is, if anything, too small given the current state of the economy -- a $600 billion reduction in government spending causes a $600 billion reduction in GDP (or about 300 billion per year).

Presently, GDP is just under $14.7 trillion, so a $300 billion change represents a 2% change in GDP. According to Okun's law, a 2% change in output corresponds to a 1% change in the unemployment rate, so this translates into, approximately, a 1% change in the unemployment rate. The labor force is presently just over 153 million, so a 1% change corresponds to around 1.5 million workers. Thus, employment would fall by 1.5 million workers in each of the two years, for a total decline of 3 million workers.

So, a $600 billion reduction is government spending over two years would raise unemployment by 1% per year, or around 3 million workers in total. We are currently down around 11 million jobs since the start of the recession, and we are not creating jobs at anywhere near the pace that is needed to reach full employment in a reasonable time period (at current rates it would be over 5 years). To stack an additional 3 million lost jobs on top of the large unemployment problem we already have would be a disaster, and I do not expect changes of this magnitude to happen despite talk of "trillions." Even a much smaller cut, say $100 billion over the next year, would still wipe out 500,00 jobs over that time period -- 2 months of job creation at present rates -- and set the recovery back considerably.

As noted above, the multiplier is much smaller when the economy is closer to full employment. Thus, when the economy is strong, the output and employment effects of deficit reduction aren't as severe. We do need to address out long-run deficit problem, and that means, first and foremost, getting the main source of the problem -- health care costs -- under control. But if we move too soon, if we make big cuts while the economy is still struggling to recover, we will do more harm than good.

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