In the world of fiscal policy, there are actually two big debates.
- One debate revolves around the appropriate size of government in the long run. Folks on the left argue that government spending generates a lot of value and that bigger government is a recipe for more prosperity. Libertarians and their allies, by contrast, point out that most forms of government spending are counterproductive and that large public sectors (and the accompanying taxes) undermine economic performance.
- The other debate is focused on short-run economic effects, and revolves around the “Keynesian” argument that more
government spending is a “stimulus” to a weak economy and that budget-cutting “austerity” hurts growth. Libertarians and other critics are generally skeptical that government spending boosts short-run growth and instead argue that the right kind of austerity (i.e., a lower burden of government spending) is the appropriate approach.
Back in 2009 and 2010, I wrote a lot about the Keynesian stimulus fight. In more recent years, however, I have focused more on the debate over the growth-maximizing size of government.
But it’s time to revisit the stimulus/austerity debate. The National Bureau of Economic Research last month released a new study by five economists (two from Harvard, one from NYU, and two from Italian universities) reviewing the real-world evidence on fiscal consolidation (i.e., reducing red ink) over the past several decades.
This paper studies whether what matters most is the “when” (whether an adjustment is carried out during an expansion, or a recession) or the “how” (i.e. the composition of the adjustment, whether it is mostly based on tax increases, or on spending cuts). …We estimate a model which allows for both sources of non-linearity: “when” and “how”.
Here’s a bit more about the methodology.
The fiscal consolidations we study are those implemented by 16 OECD countries (Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Portugal, Spain, Sweden, United Kingdom, United States) between 1981 and 2014. …We also decompose each adjustment in its two components: changes in taxes and in spending. …we use a specification in which the economy, following the shift in fiscal policy, can move from one state to another. We also allow multipliers to vary depending on the type of consolidation, tax-based vs expenditure-based. …Our government expenditure variable is total government spending net of interest payments on the debt: that is we do not distinguish between government consumption, government investment, transfers (social security benefits etc) and other government outlays. …In total we have 170 plans and 216 episodes, of which about two-thirds are EB and one-third are TB.
By the way, “EB” refers to “expenditure based” fiscal consolidations and “TB” refers to “tax based” consolidations.
And you can see from Table 5 that some countries focused more on tax increases and others were more focused on trying to restrain spending.
Congratulations to Canada and Sweden for mostly or totally eschewing tax hikes.
Though I wonder how many of the 113 “EB” plans involved genuine spending reforms (probably very few based on this data) and how many were based on the fake-spending-cuts approach that is common in the United States.
But I’m digressing.
Let’s now look at some findings from the NBER study, starting with the fact that most consolidations took place during downturns, which certainly wouldn’t please Keynesians, but shouldn’t be too surprising since red ink tend to rise during such periods.
…there is a relation between the timing and the type of fiscal adjustment and the state of the economy. Overall, adjustment plans are much more likely to be introduced during a recession. There was a consolidation in 62 out of 99 years of recession…, while we record a consolidation in only 13 over 94 years of expansion. …it is somewhat surprising that a majority of the shifts in fiscal policy devoted to reducing deficits are implemented during recessions.
And here are the results that really matter. The economists crunched the numbers and found that tax increases impose considerable damage, whereas spending cuts cause very little harm to short-run performance.
We find that the composition of fiscal adjustments is more important than the state of the cycle in determining their effect on output. Fiscal adjustments based upon spending cuts are much less costly in terms of short run output losses – such losses are in fact on average close to zero – than those based upon tax increases which are associated with large and prolonged recessions regardless of whether the adjustment starts in a recession or not. …what matters for the short run output cost of fiscal consolidations is the composition of the adjustment. Tax-based adjustments are costly in terms of output losses. Expenditure-based ones have on average very low costs.
These findings are remarkable. Even I’m willing to accept that spending cuts may be painful in the short run (not because of Keynesian reasons, but simply because resources don’t instantaneously get reallocated to more productive uses).
So if the economists who wrote this comprehensive study find that there is very little short-run dislocation associated with spending cuts, that’s powerful evidence.
And when you then consider all the data and research showing the positive long-run effects of smaller government, this certainly suggests that the top fiscal priority should be shrinking the size and scope of government.
P.S. I mentioned above that Keynesians doubtlessly get agitated that governments engage in fiscal consolidation during downturns. This is why I’m trying to get them to support spending caps. The good news, from their perspective, is that the government’s budget would be allowed to grow when there’s a recession, albeit not very rapidly. The tradeoff that they must accept, however, is that spending would be limited to that modest growth rate even during years when there’s strong growth and the private sector is generating lots of tax revenue.
Honest Keynesians presumably should yes to this deal since Keynes wanted restraint during growth years to offset “stimulus” during recession years. And economists at left-leaning international bureaucracies seem sympathetic to this tradeoff. I don’t think there are many honest Keynesians in the political world, however, so I’m not expecting to get a lot of support from my leftist friends in Washington.
[…] Dan Mitchell of CATO discusses new research showing that “fiscal austerity” via spending cuts is much better for the economy than […]
Nice overview, lots of good facts. However, you are wrong about Sweden, at least in reference to the 1990s. As I show in my book Industrial Poverty, 2/3 of the Swedish austerity package from 1995-98 consisted of tax hikes.
Here are some interesting facts that foster big government.
During the last 3 presidential elections, the percent of Democratic votes for the Presidency was 51.3 of the votes cast. For Republicans, it was 48.3 percent. That means that, on average, the election was decided by 1.5 percent of the voters – half the difference ( plus one)….the flip of a coin.
There are about 125 million votes cast in presidential elections. Government employees number about 21 million, or about 16 percent of the workforce. If government employees voted their pocketbooks, that is, routinely supporting increased public budgets, their votes would represent 10 times the number needed to swing an election. Similarly, there are about 3.3 million public school teachers, or about 2.6 percent of the voters. If they voted their pocketbooks, teachers alone would decide elections, particularly at the local level, where education expenditures routinely consume a third, or more, of the total, sucking the oxygen out of competing needs – police, roads, health care, and social services. (And that doesn’t count votes of spouses)!
Public sector employees, particularly public school teachers at the local level, are decisive in elections. That leaves 80 percent of the national workforce, those in the private sector – divided, and subservient to government.
Essentially, fiscal restraint, that is, the limitation of expenditures in public programs, faces a formidable ‘bloc’ of voters – organized, virtually to vote routinely for increases, and the political leadership that “butters their bread” – largely Democrats. So powerful is this collusive “crony” public sector force, that deficit spending becomes unrestrained at all levels – local, state, national, and international. Witness the growth of the national deficit, now at about $20 trillion. That however, is dwarfed when compared to the unfunded liability conservatively estimated to be over $200 trillion. Internationally, economies teeter under similar excesses. Unaddressed, employment, security, and the social order within, and between nations, threaten to collapse like dominoes and a houses of cards.
The need for reason, and sober leadership is made obvious by its absence. Like the Phoenix, we may have to suffer destruction by fire before civility and order can rise from the ashes of failed governance.
Jaime L. Manzano
Federal Senior Executive and Foreign Service Officer (Retired)
7904 Park Overlook Drive
Bethesda, MD 20817
301 365 4781
Much of the confusion about fiscal spending revolves around money spent. However, the best way to think about fiscal spending is to recognize that government spending allocates resources away from private markets. At any one time, the resources of an economy are fixed. If more are allocated to private markets the economy will grow at a faster rate, because private markets have profits as a guide for decision making.
It can be argued that government spending does not focus on profits, but rather societal benefits. However, that argument is only true if you have archangels running the government, rather than politicians.
Should government spending increase during recessionary periods? Probably not. Recessions are a correction phase after an accelerated growth phase, a period necessary to correct for previous over-exuberance. As Warren Buffett puts it, when the water goes out, you find out who’s been swimming naked. Government spending may buffer the down turn, but it lengthens the time for correction. Is it better to rip off the Band-Aid?
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[…] taking into account the unique economic conditions that applied for each country. Dan Mitchell summarizes the results of their […]
[…] is a review of the academic debate on whether deficits are good (the Keynesians) or bad (the austerity crowd). This literature review is necessary for that sort of article, though I think it’s a […]