Jared Bernstein posted this amazing chart yesterday. It shows Federal Reserve forecasts for GDP growth in 2012. They have steadily fallen. In 2010, the Fed forecast an impressive 4% growth for 2012. By June of this year, they have lowered that to a little over 2%. And yet the Fed is also a policymaker, rather than just an independent observer. When these forecasts start to drop, they should be spurred into action. But that hasn’t occurred.

Bernstein sees this as a modeling error throughout the government’s economic forecasts, specifically in this balance sheet recession, as it’s sometimes called:

The problem is structural, i.e., it’s in the models, which fail to adequately account for the loss of wealth that’s beset most households, the subsequent deleveraging, and the impact of these dynamics on the macroeconomy.

As I’ve stressed elsewhere, the loss of housing wealth is particularly problematic in this regard. First, as Case et al show here, the impact on consumer spending from the loss of housing wealth is particularly large (relative to standard wealth effect estimates, their estimate from lost housing wealth is 3-4 times greater).

Second, when an equity bubble bursts, like the dot.com example in the late 1990s, it mops up more quickly as “mark-to-market” takes your pet rock shares to zero pretty fast. But in a debt-financed housing bubble, “extend-and-pretend” kicks in, as banks have strong incentives to avoid admitting that non-performing loans are burning a hole in their balance sheets.

But to recalibrate the model, you have to attack the source of the problem. Actually what the Fed has said is that they need help from the legislative and executive branches with some fiscal policy solutions. Even that is off the mark to some degree, because we actually need elevated deleveraging to stop the balance sheet recession and get over the housing hump. But there’s no question that some fiscal injections will help the economy. Those aren’t coming for a variety of reasons, and this represents a real tragedy: [cont'd.]

Chicago economist Robert Lucas has ruefully remarked that “everyone is a Keynesian in a foxhole.” But once stimulus policies removed the danger of prolonged depression, ideological conservatism reasserted itself. The fact that the bond markets started betting against highly indebted governments gave fiscal hawks an excuse to cut state spending under the guise of restoring “credibility” and “sustainability”; in Britain, these ostensible virtues became the basis of official policy after the general election of 2010. Britain’s Conservative spin doctors fueled the debt aversion with images from the streets of Athens and analogies between the private and public purse. Unless the state learned to live within its means, Britain would become “another Greece.” Austerity, not stimulus, was the road to recovery [...]

For Keynesians, this is not surprising: By cutting its spending, the government is also cutting its income. Austerity policies have plunged most European economies (including Britain’s) into double-dip recessions. At last, opinion is starting to shift—but too slowly and too late to save the world from years of stagnation.

That’s from Robert Skidelsky, John Maynard Keynes’ biographer.

But there’s another element to this story, one that plays into conservative ideological thinking about government. Catherine Rampell put out an interesting analysis this week looking at trust in government, from the Gallup poll. She correlated it with budget cuts, coming to a conclusion which I believe is correct:

Declining confidence in institutions and cutting funds for those institutions can be a self-perpetuating cycle.

People lose faith in their government institutions, perhaps because those institutions are poorly run or because pundits declare that the institutions are poorly run (usually, some combination of the two, it seems). Voters and/or their politicians then sharply cut funds for those institutions. Insufficient funds and staffing then make these institutions even less effective, reducing confidence in them further and thereby prompting even more cuts. And so on.

You basically have the “drown the government in the bathtub” ethos in these paragraphs. Conservatives think government can’t do anything, and then they come to Washington to prove it. This feedback loop saps trust in government and attraction to conservative ideology. That’s especially true when you have a recession where basic needs go unmet, and government cannot seem to stimulate the kind of growth necessary to get the nation out of the hole. It speaks to the Administration’s need to capitalize on elements fully within their control, for example housing. Otherwise, they might as well be playing for the other team. Because austerity is not only a conservative solution, it reifies conservative ideas about government.