Cut and Grow? I Say No.

May 25th, 2011 at 9:11 am

Neil Irwin’s WaPo piece this AM provides a useful review of the different ways economists and politicians are thinking about the short-term impact of spending cuts on growth and jobs.

I’ve been pretty aghast to hear claims that large cuts would immediately generate job growth (and Irwin should have at least quoted someone with that view in the piece) when the opposite is almost surely the case.   You can make this a lot more complicated, but when you’re as far below capacity as we are—when so many people are unemployed, e.g.—it’s really quite simple arithmetic.  Government spending feeds right into GDP growth and cuts subtract from it.

Now, when you’re at full capacity, it’s different.  At that point you’re pouring water into a glass that’s already full so you’re just wasting water.  And you’re going to need some paper towels to clean it up (that’s inflation in this example—sorry, it’s early and I’m only partially caffeinated).

But with GDP growth just around trend (positive but not all that strong) factories with capacity to spare, and 20+ million un- or underemployed, there’s space in the glass.  In fact, if you look at the GDP or employment accounts, it’s clear that state spending contractions are a real drag on growth and jobs right now.   (Maybe I’ll try to post some graphs on this later.)

If I ran the country and had my druthers and wasn’t constrained by today’s budget politics (yes, that’s a lot of ‘ifs’), I’d do another round state fiscal relief.

The story the “cut-now-and-grow” lobby wants to tell depends not on arithmetic, but on what Krugman calls the confidence fairy (she’s good) and the crowding-out troll (he’s bad).   In a tight budget environment like today’s, politicians love the fairy because she provides free stimulus.  And since she’s a fantasy, you can attribute anything you want to her: “confidence in the markets depends on [your favorite budget cut here]!!”

Then there’s the notion that high public spending levels are crowding out private borrowing.  Again, not a plausible story with excess capacity, the Fed funds rate at zero, and companies sitting on cash that they could invest with if they saw good reasons to do so.

One final beef with this story.   Irwin cites economist Kevin Hassett at the end of the piece suggesting that cutting government benefits to individuals would be more stimulative than cutting government infrastructure.  Besides being backwards—the question is what would hurt growth least, not which “…cuts would be more beneficial”—the evidence I’ve seen, like Table 11 here, shows infrastructure in the middle of the pack in terms of stimulative impact, less than some of the major benefit programs like unemployment insurance or food stamps.

And here’s something else on infrastructure, from someone who’s spent part of a career tracking its impact: compared to the other spending programs that get resources to folks who need it and will spend it quickly, it’s slow.  Remember, at the heart of this argument is policy measures that would generate “immediate relief,” something a lot of people in this economy could use right now.

I’m all for infrastructure investment—it’s a key input to our economic productivity, security, and living standards.  But compared to spending on individuals, its stimulative impact usually occurs in the medium term, not right away.

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13 comments in reply to "Cut and Grow? I Say No."

  1. DerekSTheRed says:

    I suspect this Harvard paper will receive lots of talk from conservatives. The paper shows that cutting and growing is possible and uses examples since 1980. What they don’t mention is the affect of imports, exports, and the exchange rate. Cutting and growing should be possible if you devalue your currency and your domestic companies sell to customers in other countries. Of course even mentioning a weaker dollar will incite fire and brimstone on Capital Hill and every country can’t devalue its currency at the same time. *cough* China *cough*

  2. foosion says:

    Maybe you should try to advise the Obama administration, which doesn’t seem to understand this.

    Obama today seems to believe Hochul won in yesterday’s special congressional election due to a commitment to deficit reduction. Geithner today was happy to say that prospects are “quite good” for sizeable cuts and called realistic a budget deal that would make a “down payment” of more than $1 trillion in cuts to federal deficits over the next decade. No mention at all of counter-cyclical policy.

    If you haven’t seen it, Brad DeLong’s post “Contractionary Policy Is Contractionary” is worth reading:

  3. AB says:

    This is a great post, Jared, but as a non-economist, I have one question: what does the glass represent in your metaphor? I understand that the economy isn’t at capacity because so many people are unemployed, but I’m curious about what the conditions are that set what “capacity” is and limit the effects of government spending on employment and GDP at that point.

  4. Nylund says:

    One gets the impression that conservatives think that gov’t spending, once spent, just disappears from the economy. Maybe some gov’t spending ends up in an offshore account for some private no-bid contractor, but for the most part, eventually, gov’t spending ends up in the bank account of a private individual somewhere. It may be the construction worker that fixes highways, an engineer at Lockeed Martin, or someone who gets to keep cash in their bank account because the gov’t helped them buy food. All this extra money then, in turn, is used to buy other things which helps more sellers and retailers in the private industry. Yes, there is an argument for “crowding out” in “normal” times, but, as stated, with low interest rates, under-employment, and private firms sitting on piles of cash, its not a relevant argument for our current situation. How anyone thinks that removing this cash from individual people’s accounts (and the accounts from whom they buy stuff) will INCREASE GDP is insane. The confidence story is pure makarky. Heck, one could give an argument that the increase in demand that comes with stimulative funding may actually give private companies the confidence they need to expand operations and hire workers.

    And no, “Ricardian Equivalence” isn’t a good comeback either. People are not the entirely rational, forward-looking, and infinitely-lived representative agents so many economists assume them to be.

  5. chris says:

    OT to this essay but worthy of posting re: the last:

    “Is it possible that Democrats will squander the political advantage on Medicare that they just regained over Republicans? It could happen.

    At his weekly Capitol briefing with reporters Tuesday, House Minority Whip Steny Hoyer (D-MD) confirmed what aides in both parties have been telling reporters: Cuts to Medicare will be on the table in deficit and debt limit negotiations, led by Vice President Joe Biden.”

    • Carol says:

      It is not only possible, but entirely probable that the democrats will blow this opportunity. They have a death wish for the party, if not the country.

  6. Cahal says:

    As an interesting aside, the only theoretical argument for expansionary austerity – Ricardian equivalence – was dismissed by Ricardo himself:

    “But the people who paid the taxes never so estimate them, and therefore do not manage their private affairs accordingly. We are too apt to think that the war is burdensome only in proportion to what we are at the moment called to pay for it in taxes, without reflecting on the probable duration of such taxes. It would be difficult to convince a man possessed of £20,000, or any other sum, that a perpetual payment of £50 per annum was equally burdensome with a single tax of £1000.”

    It’s worrying that the idea is still so prevalent.

  7. String says:

    The “cut-now-and-grow” lobby doesn’t believe this foolishness. What they believe, with good reason, is that they can convince us and the middle to move in this direction and slow recovery. Remember the stimulus debate, these are the same tactics they used to slow growth for their political advantage. If Democrats oversee a resurgence of the economy, Republicans lose credibility. They are acutely aware of this reality.

    On the other hand, if they win the White House in 2012 they will have a much different policy in mind.

  8. Kevin Rica says:

    I like Krugman’s “confidence fairy” term.

    But conservative use the business confidence argument to justify what are extremely self-serving policies (never ask the barber if you need a haircut).

    However, they should not be allowed to avoid the logical implication of what they are say: “Capitalist economies have terribly fragile psyches and subject to the ‘vapors.'”

    But for the record, I believe neither the confidence argument nor its implications.

    While I believe that governments can, and do, enact stupid policies that hurt businesses, you can’t cure a recession by giving placebos (better yet, call them sugar pills) to business. If Bush’s tax cuts had worked, we wouldn’t have the current recession (and we’d have had a longer and stronger recovery).

  9. Alex says:

    economist Kevin Hassett

    Is it not a legal requirement to refer to him as “Dow 36,000 author Kevin Hassett”?

  10. Paul says:

    As a newcomer and token conservative here, I of course disagree. See, for one piece of literature out of many out there:

    It briefly addresses crowding out, unproductive spending, unrealistic multiplier effects and a few other topics.

    And a few questions for Jared: We’re undoubtedly not at “full capacity”, but what would you recognize as being at full capacity? Is there any set of circumstances where you would NOT advocate more government spending as an economic booster? Similar to the reductio ad adbsurdum for the minimum wage, if a little is good, let’s shoot for the moon– let’s have the gov’t spend 300 trillion right now, which will surely get the economy going again–and if you don’t advocate that measure, why not?

    More to the point, if we’re not at full capacity, let’s investigate some root causes: Why don’t we have more economic activity? I suspect that an unpredictable and generally hostile political and economic climate has something to do with this.

    @ nylund. Gov’t spending comes primarily from taxes (i.e. taking money from those who have earned it, typically successful and productive people) and borrowing (i.e. future taxes). A large portion of the spending goes to redistributive programs such as social security, medicare, and various other welfare programs, or to aid and grants to foreign countries, various unproductive bureaucracies, etc–you can probably pick a few that you think aren’t worthwhile. The quality of the spending matters, too. By their nature, government spending destinations remove capital from productive citizens/companies and put it in the hands of those who cannot or do not invest it (for instance, are welfare recipients better quality spenders than McDonald’s franchise owners?). You’re thinking the economy is a 0-sum game, and in fact it is not–those people may spend the money, but they do not produce the multiplier that you want them to.

    Gov’t spending does not come from nowhere–the cash does come from people who would likely be spending it, or letting banks invest it, or doing any number of other things with it. Why you prefer that the gov’t allocate the cash is beyond me.

    Cheers all– thanks for reading, and as I just stumbled on this I won’t likely be back… take care,