07/13/2010 10:56 am ET Updated May 25, 2011

Austerity Bites

There is a false dichotomy buried in the austerity vs. stimulus policy debate. Both sides share the notion that the road to economic recovery is forked, and that we must choose only one path. Paul Krugman and the spendthrifts urge us to veer left and postpone pain with a second federal stimulus. Alan Greenspan and the deficit hawks believe we must make a miserly right turn and slash budgets to the bone.

Unfortunately for all of us, neither of these singular tactics holds much promise. Both the avenue of self-denial, and the boulevard of self-indulgence have failed to spark real growth. Consider the evidence:

We've now spent or committed nearly $600 billion of the $792 billion stimulus package. US unemployment stubbornly sits at 9.5%.

It's hard to argue spending works.

We haven't tried austerity yet, but look no further than Spain and Ireland to see the fiscal hatchet is no jobs incubator. As soon as Spaniards approved severe budget cuts in May, their unemployment rate promptly rose from 19.7% to 19.9%. Ireland adopted an austerity plan a full two years ago. Last month, unemployment there shot from 12.9% to 13.3%.

Clearly, austerity doesn't guarantee growth either.

So what are we to do, when both austerity and stimulus prove to be feeble tools in this economic reconstruction project?

I humbly submit we should embrace both at the same time.

Stimulus and austerity are not mutually exclusive strategies. The question is not whether to cut or spend. The question is what to cut. . .. and what to spend on.

The first stimulus, otherwise known as the American Recovery and Reinvestment Act, flooded the domestic economy with easy money, but the cash was unwisely spent. ARRA was largely a band-aid for faltering state and local governments. It bore no resemblance to the bold, inventive Keynesian programs of the New Deal. We got no Tennessee Valley Authority to build dams and modernize infrastructure in the South. We got no Works Progress Administration to build roads and libraries in the West. The real value of Roosevelt's grand public works scheme was not in temporary paychecks doled out to unemployed citizens, but rather in the future efficiencies we gained from an interstate highway system and a modern electrical grid. Times were grim in the 1930s, but stimulus spending was not aimed at avoiding present day pain. It was aimed at speeding some future recovery.

If lawmakers approve a second round of stimulus, they should do so with an eye toward history. Funding should be limited to new initiatives like high-speed rail, green energy, and nanotechnology. Despite all the talk of "shovel ready" programs, the Congressional Budget Office says 80% of 2009 stimulus dollars went to prop up Medicaid, Social Security, grants to state and local government, and student aid. These are not new, growth inspiring investments. They are transfer payments that will make fiscal reckoning even more painful when state governments lose the stimulus next year. A generation can postpone austerity. . . but it cannot postpone reality.

Of course, even if we adopt austerity measures now, they'll be ineffective if they fail to tackle tax reform and entitlement reform.

True austerity is not defined by one-time budget cuts or a few public sector layoffs. True austerity refers to cutting structural deficits. What really scares the bond markets is that Social Security is insolvent. Foreign creditors are skeptical, not because we cut taxes in the face of a budget deficit. . . but because our 8,000 page tax code is a perpetual playground for special interest loopholes. These are not "this year" problems. They are "next decade" problems. The federal government must stop making promises to its citizens that it cannot conceivably keep. That's what destroyed the world's confidence in Greece... and confidence can turn just as quickly on the US.

Republicans in Congress are currently balking over a $33 billion proposal to extend unemployment benefits in 2010. They should approve the extension. Providing temporary benefits to the jobless is the compassionate thing to do, and it will have no appreciable impact on our gaping national debt. Global bond markets yawn at such trifles. A sincerely austere budget would instead concern itself with much bigger projects, like overhauling the way Social Security benefits are calculated. For example, raising the retirement age to 70. Or how about means testing Social Security so benefits grow more slowly for affluent retirees? These structural cuts may seem politically impossible, but if President Obama got behind them, he could call the bluff of Republicans and muscle reforms through.

Austerity bites... but these lean times may be our best chance to adopt the kind of entitlement and tax reform lawmakers have talked about since the 1980s. Rightsizing Social Security and simplifying the tax code would give the world renewed confidence in our fiscal backbone. Even better, these reforms would provide the political cover necessary to pass a stimulus modeled on 1933... rather than 2009.