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The Crumbling Case for Cutting Spending to Stimulate the Economy

Empirical support for the view that sharp, immediate cuts in government spending would be good for the U.S. economy was never strong, and it’s getting weaker.

The Economist is on the case, highlighting two new studies showing that austerity and growth don’t mix in the short term.  That has been the conventional wisdom for some time.  Recently, however, advocates of quick, severe cuts in government spending have pointed to empirical studies of major deficit-reduction initiatives by other countries.  These studies, they argue, show that programs composed largely of spending cuts are more likely to be successful at stabilizing deficits — and less harmful (and even beneficial) to the economy in the short run — than programs with a larger tax-increase component.

The first new study is from the International Monetary Fund.  In its 2010 World Economic Outlook, the IMF put the kibosh on the idea that deficit reduction would boost economic growth in the short run.  IMF researchers have now presented a revised and extended version of the analysis, which reinforces the IMF’s earlier conclusion.

The second new study, by Roberto Perotti, backs up those of us who have been arguing for some time that these international examples have little in common with current U.S. budget and economic conditions.  What makes the Perotti study so significant is that he has been one of the leading researchers cited by advocates of sharp, immediate cuts in government spending.

Perotti conducted detailed case studies of the four largest multi-year deficit-reduction efforts that researchers have commonly regarded as spending-based.  He found that they were actually much smaller, and much less tilted toward spending cuts, than previous studies had assumed.

Perotti also found that all four countries’ economies benefited from a rapid decline in interest rates and a moderation of wage growth, which in turn made domestic firms more competitive internationally; an expansion of exports was key to economic growth in three of the four cases.  These findings support the testimony of both Simon Johnson and me at a recent congressional hearing that U.S. conditions are far different from those in the deficit-reduction episodes that supporters of sharp spending cuts have cited as successful:

  • The United States does not face a debt crisis (unless policymakers commit the unforced error of failing to raise the debt ceiling in a timely way), so interest rates here are already very low.
  • The United States is still in a deep economic slump with very high unemployment; there is no persistent upward pressure on wages or prices.
  • Since interest rates are already low, the United States doesn’t have the option of lowering them much further in order to offset the contractionary effects of deficit-reduction measures like large spending cuts.
  • It would be very difficult for the United States to increase exports enough to offset those contractionary effects.  Large-scale deficit reduction is more likely to strengthen the dollar than weaken it, which would make U.S. exports less competitive.  And other developed countries also are trying to reduce their budget deficits and get out of an economic slump by expanding their exports.

In short, the more closely you look at the evidence for the claim that cutting federal spending dramatically right now would be good for the economy, the less convincing that claim becomes.