Like a game of wonk whack-a-mole, there’s an argument that says that if we cut the deficit in the middle of a slump and weak recovery we can spur growth. No matter how much you hit it with a foam rubber mallet of OECD data and white papers, the argument just jumps up through another hole.
Recently governments, economists, and international financial institutions have been debating the merits of further fiscal stimulus to combat the Great Recession versus fiscal austerity or “adjustment” – that is, higher taxes and/or lower government spending – to combat budget deficits. Some supporters of austerity have gone as far as arguing that fiscal adjustment could restore economic growth. These analyses are being touted to oppose increased stimulus to boost the economy. This paper examines the arguments for austerity and demonstrates that current economic conditions in the United States do not support the case for fiscal adjustment.
Baker looks over the type of arguments made by Alberto Alesina and Silvia Ardagna, as well as a new report by Goldman Sachs that makes the same type of argument. After taking apart their argument and showing how it requires a lot of things to be true for the United States that simply aren’t true, he concludes:
There has been a considerable effort to tout the merits of fiscal austerity as a route to restoring growth. This argument has been put forward in direct opposition to arguments for increased stimulus for boosting the economy. While there may be a case that lower deficits can foster growth under some circumstances, the evidence presented in the Broadbent and Daly paper does not suggest that a movement toward lower deficits in the current economic situation in the United States would be expansionary.
Very few of the countries in which fiscal austerity was associated with more rapid growth adopted austerity at a time when the economy was far below its potential level of output. In none of the cases were they are as far below as the United States is today. In all of the cases where there was a substantial output gap, the country was far more engaged in international trade than the United States. Trade provided a source of demand that cannot have anywhere near as large an impact in the United States at present.
Finally, all the countries that successfully used austerity to boost growth had much higher interest rates than the United States does at present. This meant that there was substantial room for rates to decline following the imposition of austerity.
The differences between the United States in 2010 and the countries that have successfully gone the route of fiscal austerity to boost growth are large and are very central to the adjustment process. In short, in the current economic environment, the circumstances do not exist for fiscal austerity in the United States to lead to more rapid growth. While a quick return to normal levels of unemployment may not be important to those who are primarily dependent on profits or run large corporations, for most of the country, it is essential to their well-being.
What I’ve noticed about this “growth through austerity” argument is that it requires something else to move. You can cut your way out of a recession as long as you can lower interest rates. Or export your way out of the recession. Or if you are comfortable blowing up your debt-to-GDP ratio. Or if you let unemployment skyrocket further. Or if you are a really small country. The big two are interest rates and exports, and neither are available at the zero bound or in a global recession. And without being able to put this in motion an austerity measure would be very, very ugly. There’s a reason economists and governments know to cut during the upswing and not during a weakened state. Dean finds that when you consider the potential level for output it is these types of arguments are even worse.
The IMF went after similar arguments in Will it hurt? Macroeconomic effects of fiscal consolidation (which we talk about here), and Arjun Jayadev and I did the same as well in our working paper The Boom Not The Slump: The Right Time For Austerity. We found that most of these scenario are really countries cutting their deficits during a growth period, which is exactly what you’d expect a rational government to do.
The argument that cutting the deficit right now would make growth happen requires a situation that is the complete opposite of where the United States finds itself; I wish the remaining members of the elite discourse who’d like to convince themselves otherwise would realize this.