New Working Paper. “The Boom Not The Slump: The Right Time For Austerity”

Hello all. Since EPI put out a briefing paper critically analyzing the Reinhart and Rogoff arguments about debt-to-gdp ratios and growth, Arjun Jayadev and I over at Roosevelt Institute decided to go through that Alberto F. Alesina and Silvia Ardagna paper (“Large Changes in Fiscal Policy: Taxes Versus Spending”) and figure out what was going on with it.

We’ve written it up into a working paper: The Boom Not The Slump: The Right Time For Austerity (pdf). I hope you check it out.

We even got a Keynes quote from 1937 in it: “The boom, not the slump, is the right time for austerity
at the Treasury.” What we found:

Key Findings

- Countries historically do not cut their deficits in a slump, instead addressing these problems during a non-recessionary time.

- When countries cut in a slump, it often results in lower growth and/or higher debt-to-GDP ratios. In very few circumstances are countries able to successfully cut during a slump, and this happens only when either interest rates and/or the exchange rates fall sharply.

- In our analysis, we find that there is no episode in which a country facing the same circumstances as the United States (recent recession, low interest rates, high unemployment) has cut its deficit and succeeded in reducing its debt through growth.

- We conclude that there is little evidence provided by A & A that cutting the federal deficit in the short-term, under the conditions the United States currently faces, would improve the country’s prospects. It may even make the United States’ situation far worse.

And our introduction:

Should the United States cut its deficit in the short term? This has been the subject of intense debate among politicians, policy analysts and thinkers over the past year. What are the consequences of cutting the deficit with interest rates low, unemployment high and growth uncertain?

A recent paper by Alberto F. Alesina and Silvia Ardagna (2009), “Large Changes in Fiscal Policy: Taxes Versus Spending” (henceforth A & A), looks at a cross section of deficit reduction policies among different countries. It examines examples where large-scale deficit reduction is associated with economic expansion and where the debt-to-GDP ratio falls in the medium-term (3 years after the adjustment). Based on this research, many popular commentators suggest that the U.S. can adopt such a policy and grow.

However, upon a further examination of the data such a conclusion is unmerited. The overwhelming majority of the episodes used by A & A did not see deficit reduction in the middle of a slump. Where they did, it often resulted in a decline in the subsequent growth rate or an increase in the debt-to-GDP ratio. Of the 26 episodes that they identify as ‘expansionary’, in virtually none did the country a) reduce the deficit when the economy was in a slump and b) increase growth rates while reducing the debt-to-GDP ratio. The sole example not covered by those two qualifiers can be explained by a combination of two policy maneuvers that are not easily available to the U.S. at the moment: currency depreciation and interest rate reduction.

We expand on their initial examination and cover the entire data set of 107 observations, finding very little evidence for success when cutting in a slump—in our terminology, when the growth rate in the previous year was lower than the average growth rate over the past three years. Only one additional case out of 107 can be seen as an example of success in fiscal consolidation, and we show that this does not bear scrutiny either.

And here is the key chart for me. Here are the example they choose, and as you can see almost all of these examples do not cut during a slump or they experience lower growth in the following years. The only two that don’t do this are Ireland (1987) and Norway (1983), both examples (we cover this in depth in the paper) which are not relevant for our current situation.

(Updated 8/23: New Graph with correct formatting and slight change replaced old graph.)

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13 Responses to New Working Paper. “The Boom Not The Slump: The Right Time For Austerity”

  1. Sue says:

    You can’t really think anyone already idealogically committed to the puritanical “cut-in-a-slump because people-deserve-to-be-punished-for-excess” crowd is going to care for a second about a bunch of third rate unimportant countries they’ve hardly heard of on the other side of the planet? (Their characterization). The USA is different, according to that crowd, s-p-e-c-i-a-l.

    That’s the whole problem. Not the historical facts. They don’t want to listen to facts and they don’t want to see tables of numbers. They have a quasi-religious belief and they know what they know. The rest of us are just talking to ourselves.

    I wish I was exaggerating but don’t think I am. To get the message out the arguments need to be presented simply, repeatedly, with pictures. Even then it’s hopeless. Try talking to the average right wing voter about currencies and interest rates, they don’t want to hear it (“that has nothing to do with me” is what I hear if I talk about international comparisons). I fear it starts with the education system, an innumerate populace can’t grapple with the complexities and are prey for manipulative false prophets (eg cut taxes for the rich because you’ll be rich one day). Start with the schools.

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  5. Sid says:

    Let’s see, cutting the deficit at a time when growth in GDP is either low or negative, and unemployment is high is another name for restrictive fiscal policy. What person who has even a faint knowledge of economics would think such a policy would lead to expansion. Hence the conclusions of this paper.

    The only way in which reducing federal stimulus to the economy can work is if private borrowing/investment replaces the lost public borrowing/investment. Does anyone see this happening in this economy, even with nominal interest rates at near record low levels?

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  7. I talked about Alesina on Marginal Revolution back here:

    http://www.marginalrevolution.com/marginalrevolution/2010/06/one-of-my-favorite-david-brooks-columns.html

    The comments demonstrate why I have stopped most of my commenting on blogs. Many commenters don’t even bother to read the sources cited. In other words, they comment without even taking the time to consider the evidence given. Hence, I’ve stopped reading the comments on most blogs, and I don’t think it’s fair to ask people to read me when I’ve given up on reading them. I still read the blogs, though.

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