A lot of people have recently asked me why we’re stuck in this policy vise-grip, targeting spending cuts and deficit reduction when we should be targeting job growth.
There’s no single perp here—there are numerous explanations, including politics and ideology of course, the changing views of the electorate on the effectiveness of Keynesian interventions, and the fact that normal people don’t readily do counterfactuals.
By that, I mean we did the Recovery Act, and it demonstrably helped, but the unemployment rate still went up and hasn’t come down much. Independent analysts, including the CBO, make the case that the economy would have been worse without the stimulus, but good luck with that one in a climate where people really don’t want to see their much-needed, hard-earned income spent on stuff they’re sure is wasteful.
OK…but how do you get from “stimulus doesn’t work” to a particularly unfortunate strain of the current policy debate: “the best way to stimulate job growth now is to aggressively cut gov’t spending.”
It flies in the face of logic that in an economy like ours that’s operating significantly below capacity—like with 20+ million un- and underemployed—that cutting spending would help. But the argument got a lot of oxygen from an academic paper that’s been making the rounds (by Alesina and Ardagna—or AA), allegedly supporting the view that cutting spending isn’t contractionary, and can even be expansionary.
My colleague Chad Stone has been taking on what he aptly calls the new voodoo economics (see this and the links therein). In his latest post, he reviews an important new paper (hat tip: SL) from the Congressional Research Service that explains how AA’s findings fail to support the idea that if we want to expand, we need to contract.
Based on international evidence, AA claimed to find that “expansionary fiscal adjustments”—episodes of deficit reduction that led to growth—were largely driven by spending cuts. As you can imagine, this has a lot of conservatives in a deep swoon. Combine it with the Laffer Curve, and you’ve got the R’s complete toolkit: cut taxes to gain revenue; cut spending to boost growth.
But alas, it doesn’t work. As can be seen from the CRS figure below, there is something quite unique in AA’s examples of “successful” fiscal adjustments. Period T-1 is the year before the adjustment (deficit reduction) and period T is the year in which it took place.
What the figure shows is that the countries in the AA study deemed successful–where spending-based deficit reduction led to growth–lowered their deficits when their economies were pretty much back to full strength. The second bar (“all unsuccessful”) shows that if you tried deficit reduction when you were below full strength, it hurt your growth.
And—drum roll please—even those unsuccessful adjustment were made in conditions FAR BETTER than where the US economy is right now. (See fourth bar in both panels; ignore the third bars).
What AA actually find is that if your economy is healing—if you’re almost back to full employment—go ahead and start lowering your deficit. If you’re far away from full employment, do not screw around with deficit reduction. And we are very far away from full employment.