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International Evidence Provides Poor Guide for U.S. Budget Policy

March 21, 2011 at 10:16 AM

Joint Economic Committee (JEC) Republicans issued a report last week arguing that cutting government spending is the key to both long-run fiscal stability and economic growth -- and that the sooner we start down that path, the better. The paper cites empirical evidence concerning deficit-reduction efforts in numerous countries over the past several decades that, at first glance, seems to support their claim. But, in reality, this evidence has little relevance to the fiscal and economic challenges facing U.S. policymakers.

The United States faces the short- to intermediate-term challenge of recovering from its greatest economic slump since the Great Depression. Our chart book documents the substantial economic slack and excess unemployment that remain almost two years after the recession bottomed out.

But the United States also faces the longer-run challenge of stabilizing the federal debt, which is on an unsustainable path. This long-term problem was evident before the recession hit, and the spike in the budget deficit due to the recession made little difference to the long-term problem.

Federal Reserve Chairman Ben Bernanke has warned against an immediate, sharp reduction in federal spending, saying at a recent congressional hearing, "the cost to the recovery would outweigh the benefits in terms of fiscal discipline." Emphasizing the importance of taking a long-term view, he said, "We need to show that we have a plan that will carry us forward for the next decade at least, that will produce consistent reductions in that deficit over time, and that has the benefit of allowing us to think it through."

The Republican JEC report reaches a different conclusion. It claims that "a growing body of empirical studies proves that fiscal consolidation programs based predominantly or entirely on government spending reductions are far more likely to be successful" at stabilizing deficits than programs based on tax increases [emphasis added]. The report argues that "quick, decisive government spending reductions" are a key to success and that deficit-reduction programs focusing on spending cuts "may even boost the real GDP growth rate in the short term under certain circumstances."

The studies on which the Republican JEC report is based, most prominently one by Harvard economists Alberto Alesina and Sylvia Ardagna, examine disparate countries facing disparate economic and budget situations under disparate global economic conditions. Their limitations deserve much greater scrutiny. We are preparing a fuller analysis, but here are three preliminary observations:

  • Evidence that cutting spending increases GDP in the short term is weak. The International Monetary Fund has concluded with regard to Alesina and Ardagna's study, "The idea that fiscal austerity triggers faster growth in the short term finds little support in the data."
  • Evidence that a deficit-reduction program focused on spending cuts can promote short-term growth and long-term fiscal stability is slim. Alesina and Ardagna identified 107 episodes of "large" deficit-reduction programs. Among these, we count only nine that they characterized as both "successful" (i.e., the program stabilized the debt) and "expansionary" (i.e., it did not harm economic growth in the short term). All nine occurred in small, mainly Scandinavian economies: Finland, Ireland, the Netherlands, New Zealand, Norway, and Sweden.
  • U.S. macroeconomic and budget conditions aren't right for sharp spending cuts. Mike Konczal and Arjun Jayadev examined the specific episodes Alesina and Ardagna cited in which spending cuts boosted short-term growth. They found that none of them took place in a country still feeling the effects of a large recession as the United States is now, with substantial economic slack, tepid economic growth, and high unemployment.

The countries that boosted growth could do so because falling interest rates from an expansionary monetary policy stimulated investment, because a depreciating currency stimulated net exports to cushion the drop in consumption stemming from the spending cuts, or some combination of the two. The United States doesn't have these options: interest rates are already very low and our major trading partners are still feeling the effects of the financial crisis and recession.

The premise of the JEC Republican report is that the United States is already in the midst of a debt crisis and immediate action is imperative. Yet investors believe otherwise, as demand for U.S. securities remains strong and interest rates remain at historic lows. Similarly, the Federal Reserve remains more concerned about high unemployment than an outbreak of inflation, and Chairman Bernanke is cautioning against immediate sharp spending cuts.

In essence, the JEC Republican report tries to put an academic gloss on the current Republican voodoo economics claim that government spending is crowding out productive private investment. That argument would have more force if the economy today looked more like the economy in the 1990s expansion -- the longest in our country's history and the last time we had a balanced budget. But in today's economy, weak demand, not competition for funds, is the much more plausible explanation for inadequate investment.

By the way, one of the key deficit-reduction measures in the 1990s was raising taxes on top earners, over Republican warnings that that would wreck the economy. The JEC Republican report's claim that spending cuts are the only way to reduce the deficit and that tax increases "are the bane of economic growth" is deja voodoo all over again.