Why the 'Growth Through Austerity Deficit Reduction' Theory Will Fail

by: Rortybomb

Ezra Klein notes that the Tea Party and Austerity Now wing of the conservative party have won a huge victory, and the Democrats a huge loss. Now that Obama and the Democrats are owners of the argument that we need to cut the short-term deficit immediately, and implicitly that can get growth through austerity, it’s worth a second to go through how this is supposed to work, and how it will fail.

The History of Our Current Path

Tim Fernholz and Jim Tankersley have a great article, GOP Prescription: Spending Cuts and Lower Wages Equal More Jobs, where they dig into the current economic rationality behind the push for short-term spending cuts. Fernholz/Tankersley link to a GOP report, Spend Less, Owe Less, Grow the Economy. That report is based on an AEI study, A Guide for Deficit Reduction in the United States Based on Historical Consolidations That Worked. And that study is based on a 2009 study by Alberto Alesina and Silvia Ardagna of Harvard, titled Large changes in fiscal policy: taxes versus spending.

This last study has a bit of a history in the economic blogosphere. David Brooks introduced it into pundit commentary with his June 2010 article Prune and Grow, noting “Alberto Alesina of Harvard has surveyed the history of debt reduction. He’s found that, in many cases, large and decisive deficit reduction policies were followed by increases in growth, not recessions.” Centrists rejoiced! Ryan Avent at the Economist, whose BS detector is very sharp, immediately noted that Alesina was looking at cuts “without considering the dynamics of these adjustments…There is little reason to believe that sharp fiscal adjustments in the current American context will produce growth…” and that the countries Alesina cited didn’t seem to match up.

Around the same time Roosevelt Institute Senior Fellow Marshall Auerback looked at the arguments over Canada in the 1990s, which was being promoted by the English government as a kind of growth-through-austerity poster child, and found that Canada’s experience was primarily the result of the growth of exports and expansive monetary policy. We all noted that this kind of drunk-under-the-spotlight approach to historical examination characterized a lot of the research on this topic.

With that in mind, Arjun Jayadev and I dug into the examples Alesina used that supposedly proved the case for growth-through-austerity, in The Boom Not The Slump: The Right Time For Austerity, and found that in virtually all the cases the adjustments were made when the economy was healthy, and in the few cases where it was not there was an export-driven growth or interest rates were lowered. Shortly after that, the IMF put out a paper, Will it hurt? Macroeconomic effects of fiscal consolidation, that was also summarized by The Economist as Does fiscal austerity boost short-term growth? A new IMF paper thinks not: “[The IMF] finds that the typical such episode is clearly contractionary: a fiscal consolidation equivalent to 1% of GDP leads on average to a 0.5% decline in GDP after two years, and to an increase of 0.3 percentage points in the unemployment rate. Spending cuts do less damage than tax rises.”

The hits kept coming. Dean Baker and CEPR took apart the argument as well in their report, The Myth of Expansionary Fiscal Austerity (full pdf here). And Roosevelt Institute Senior Fellows Thomas Ferguson and Robert Johnson, took this argument apart as part of their paper on the deficit, A World Upside Down? Deficit Fantasies in the Great Recession, where they distinguished between budget whales and minnows (more on that in a second).

I had assumed the IMF and the Economist writing that these austerity dreams were too harsh and too contractionary (the IMF!) would cause some people to back off relying so much on this argument. But in December, AEI redid the analysis, and now it is the core of the GOP’s argument.

(Side note: So if Arjun and I just didn’t do the last part of our analysis where we actually dug into larger economic reality of these “growth” episodes, did it like the conservatives did it, we could be running the GOP’s economic policy? Huh. I may have to consider switching team – you’d keep all the stuff on this blog a secret between us, wouldn’t you?)

How This Is Supposed to Work, And Why It Will Fail

Picture this growth-through-cutting-the-deficit argument as an elaborate version of that board game Mousetrap. Turn the crank, a boot kicks a bucket, a bunch of stuff happens, the net falls. In the conservative argument, you immediately cut the deficit in a fragile recovery, a boot kicks a bucket, a bunch of stuff happens, and then we get growth, lower unemployment, and a healthier economy.

But what’s the bucket and what’s the stuff that is supposed to happen? Broadly speaking, we found that the “growth through austerity” argument requires one of a few specific things 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. The normal way this is supposed to work won’t work for us, because none of these things can move for the United States.

Now the Republican plan has several mini-buckets that get kicked. There’s the create unemployment to reduce unemployment argument which has already been taken apart. There’s the “government asset sales and the privatization of government-owned enterprises and commercial functions both generate government receipts and increase economic efficiency” part, which I’m sure in no way will be a crony-style clusterf**k designed to make campaign contributors happy. Crony privatization worked so well in Russia, I’m sure it’ll be fine here.

It Fails Its Own Theory

But here’s their real argument: “[countries] would be better off with sharp and sustained reductions in government spending because “cold shower” fiscal consolidations send convincing signals to financial markets about the political will of governments to achieve fiscal retrenchments. This approach is viewed as more effective than cuts phased-in or scheduled for the distant future.”

This is what is supposed to kick the bucket: by having serious cuts enacted early and quickly, even if they aren’t necessarily important cuts, we can prove to the financial markets we are serious about our debt. I don’t think this is relevant for our situation, but even if I did there are two major problems with this given what the GOP (and now Democrats) are trying to do.

1. If all we are doing is changing the balance of power in our society, then this can’t work. If we are cutting money for Planned Parenthood and the Special Olympics, which are the kinds of cuts we see in this budget, and then immediately offsetting them with corporate tax cuts or with extending the Bush high-end tax cuts so that they function as deficit neutral, we haven’t shown the bond market we are serious. That’s what Ryan McNeely saw in NJ – no smaller government, not even smaller deficits, just a rebalancing of power. Spend less on poor people, more on rich people. Not exactly the “political will” to get serious.

2. In their paper, Johnson and Ferguson discuss the idea of whale watches and the budget. If we need a “cold shower” (shock treatment!) budget cut because the bond market is worried about both the US long-term debt and our political will in changing it, then these little spending cuts aren’t going to make a difference. The important interests, the whale watches, are things like the military budget, long-term health care costs, the possibility of another financial crash, the broken Senate, money and politics, and I’d add the cost of the guard labor necessary to keep 1%+ of the population incarcerated.

These budget cuts are entirely minnows. If we release a minnow, it’ll just be eaten by a whale. If we cut funding for the Special Olympics do we honestly not believe it’ll just be reallocated to the military, or health-care costs, or to tax cuts for the top 1%? And if we know that you can bet the bond market knows that. This theory requires the bond market to be terrified of a permanent rent-seeking hegemony of people with challenges getting to compete in sports while being recognized as equals among each other in a public space and poor women having reasonable access to pap smears, and thus we need to smash the Special Olympics and Planned Parenthood immediately to show “political will.” It just doesn’t make sense within its own theory.

The current path is sustainable. Run a short term deficit to help with unemployment. Remove the Bush tax cuts for the medium term deficit, tinker with Social Security at some point and deal with health care for the long-term deficit. That’s what credibility looks like for the deficit. All this other stuff is a sideshow.

UPDATE: More on how this has been working out in England in the next post.