Category Archives: Austerity

Has the Sequester Hurt the Economy?

Several weeks ago, Steve Forbes argued that the federal government spending cuts known as the “sequester” are actually having beneficial effects on the US economy, and not slowing growth as many economists and pundits in the media have claimed. Forbes’s statement attracted critics, and many economists have expressed skepticism about the sequester too. One economist even went so far as to say, “The disjunction between textbook economics and the choices being made in Washington is larger than any I’ve seen in my lifetime.”

So have the sequester cuts hurt the economy? One possible answer comes from a new paper by Scott Sumner of Bentley University. Sumner argues that cuts to government spending don’t have serious deleterious macroeconomic effects when the Federal Reserve is targeting inflation. This is because the Fed ensures that prices stay stable under an inflation targeting regime, which keeps demand stable even in the face of government spending cuts. Similarly, when the Fed stabilizes the price level it also offsets any beneficial effects that fiscal stimulus might have, which helps explain the lackluster results from the 2009 American Recovery and Reinvestment Act (aka the “stimulus”).

Implicit in Sumner’s theory is that expansionary austerity, or the idea that the economy can grow even in the face of large government spending cuts, is indeed possible. Some of my colleagues at the Mercatus Center have described other ways in which expansionary austerity is possible.

Luckily, there are still things Congress can do to improve the economic outlook, even as spending cuts take hold. Lawmakers can enact policies that boost the performance of the real economy. By this I mean policies that increase the amount of real goods and services the economy produces, as opposed to policies that affect demand (i.e. spending).

One example is reforming the regulatory system, which discourages production of all sorts. With over 174,000 pages of federal regulations in place, there must be a few obsolete or duplicative rules that can be eliminated to relieve the burden on businesses and entrepreneurs. Congress could also reform the tax code, with its perverse incentives and countless carve outs for special interests.

Starting new government programs isn’t likely to do much to benefit growth. New projects take too long to implement, politicians waste too much money on silly boondoggles, and monetary policy will likely offset any beneficial effects anyway. If Congress wants to do something to improve growth, it should focus on creating a regulatory and tax environment that encourages investment and entrepreneurial risk taking.

Eileen Norcross on News Channel 8 Capital Insider discussing Virginia and the fiscal cliff

Last week I appeared on NewsChannel 8’s Capital Insider to discuss how the fiscal cliff affects Virginia. There are several potential effects depending on what the final package looks like. Let’s assume the deductions for the Child Care Tax Credit, EITC, and capital depreciation go away. This means, according to The Pew Center, where the state’s tax code is linked to the federal (like Virginia) tax revenues will increase. That’s because removing income tax deductions increases Adjusted Gross Income (AGI) on the individual’s income tax filing (or on the corporation’s filing) thus the income on which the government may levy tax increases. According to fellow Mercatus scholar, Jason Fichtner, that could amount to millions of dollars for a state.

On the federal budget side of the equation,the $109 billion in potential reductions is now equally shared between defense and non-defense spending. Of concern is the extent to which the region’s economy is dependent on this for employment. Nearly 20 percent of the region’s economy is linked to federal spending. Two points: The cuts are reductions in the rate of growth in spending. For defense spending, they are relatively small cuts representing a return to 2007 spending levels as Veronique points out. So, these reductions not likely to bring about the major shakeup in the regional economy that some fear. Secondly, the fact that these cuts are causing worry is well-taken. It highlights the importance of diversification in an economy.

Where revenues, or GDP, or employment in a region is too closely tied to one industry, a very large and sudden change in that industry can spell trouble. An analogy: New Jersey’s and New York’s dependence on financial industry revenues via their income tax structure led to a revenue shock when the market crashed in 2008, as the New York Fed notes.

On transportation spending there are some good proposals on the table in the legislature and the executive. Some involve raising the gas tax (which hasn’t been increased since 1986), and others involve tolls. The best way to raise transportation revenues is via taxes or fees that are linked to those using the roads. Now is no time to start punching more holes in the tax code to give breaks to favored industries (even if they are making Academy-award quality films) or to encourage particular activities.

Virginia’s in a good starting position to handle what may be in store for the US over the coming years. Virginia has a relatively flat tax structure with low rates. It has a good regulatory environment. This is one reason why people and businesses have located here.

Keep the tax and regulatory rules fair and non-discriminatory and let the entrepreneurs discover the opportunities. Don’t develop an appetite for debt financing. A tax system  is meant to collect revenues and not engineer individual or corporate behavior. Today, Virginia beats all of its neighbors in terms of economic freedom by a long shot. The goal for Virginia policymakers: keep it this way.

Here’s the clip

Is the United Kingdom Savagely Cutting Spending?

In new Mercatus research, UK-based economist Anthony Evans goes in search of the data. He finds:

  • The UK government’s response to the recession has been to eliminate the structural budget deficit over the medium term.
  • There are changes in the composition of government spending but not a fall in the absolute level.
  • Forecasts of falling government spending as a proportion of GDP are due to implausible growth forecasts rather than an absolute reduction in spending.
  • History indicates that the government overestimates its ability to fund austerity through spending cuts, and therefore above-expected tax rises are likely.

Much more here, including lots of great graphs.

Behold the Savage Austerity

If you are a journalist or a commentator and you have ever uttered or written the word “austerity,” I hope you spend some time with this chart:

Vero offers some excellent comments here:

These countries still spend more than pre-recession levels

France and the U.K. did not cut spending.

In Greece, and Spain, when spending was actually reduced — between 2009–2011 — the cuts have been relatively small compared to the size of bloated European budgets. Also, meaningful structural reforms were seldom implemented.

As for Italy, the country reduced spending between 2009 and 2010 but the data shows [an] uptick in spending 2011. The increase in spending represents more than the previous reduction.

More On UK “Austerity”

There have been a lot of good things written about UK austerity since my post last week. Here is a quick round-up:


Yesterday, Veronique noted that the meanings of words often get jumbled when politicians and pundits talk about austerity. Tax increases, spending cuts, and structural reforms all fall under the label “austerity.” But only some of these measures actually work. And only some of them are actually being tried. Maybe it is time for some new words?

On Sunday, Anthony Sanders posted a number of informative charts showing recent trends in the UK economy, including: repeated dips into negative GDP growth over the past couple of years, massive sovereign debt, rising unemployment rates, and an over-built financial sector. On the plus side, the UK is still paying comparatively low interest rates on its debt and its housing market has not fallen as far the US’s.

Lastly, Anthony Evans sends me this Allister Heath piece which sheds some light on what has actually happened in the UK:

Current spending rose in cash terms from £604.8bn to £617bn in 2011-12. The OECD says UK public spending was 49.8 per cent of GDP in 2011. Public sector net borrowing remains at a catastrophic 8.3 per cent of GDP. All of this remains utterly unsustainable – yet the public have wrongly been told that the UK “is tackling its debt”. Osborne has been a disappointing chancellor – but not for the reasons cited by the left.

Photo by DoctorWho/flickr

Does UK Double-Dip Prove that Austerity Doesn’t Work?

The U.K. has slipped back into recession and Paul Krugman thinks this is evidence that austerity doesn’t work. Is it?

There are three questions with austerity:

  1. Will it work? Will it actually cut the debt?
  2. Will it hurt? Will it harm the economy or might it actually be stimulative?
  3. What mix of spending cuts and tax increases yield the best answers to questions 1 and 2.

Here is what the data says (and there is a lot of it):

  1. Sadly, most austerity efforts fail. According to research by Alberto Alesina, about 84 percent of fiscal reforms fail to substantially reduce a nation’s debt-to-GDP level.
  2. We’ve known for a while that austerity can be stimulative. Even left-of-center economists such as David Romer have acknowledged this possibility. But the evidence on this is decidedly mixed. As Alesina put it in his Mercatus working paper, austerity is about as likely to be stimulative as…well…stimulus. And we know the economics profession is quite divided on stimulus. So you shouldn’t hold your breath hoping austerity will boost economic growth. But remember, that’s not why we should be pursing austerity. We should pursue austerity because we know that we are on an unsustainable fiscal path and that in the long run, too much debt is very bad for growth. Furthermore, we know that the longer we put off reforms, the more painful they will have to be.
  3. Lots and lots of papers* have now studied this question and the evidence is rather clear: the types of austerity that are most-likely to a) cut the debt and b) not kill the economy are those that are heavily weighted toward spending reductions and not tax increases. I am aware of not one study that found the opposite. In fact, we know more. The most successful reforms are those that go after the most politically sensitive items: government employment and entitlement programs. Lastly, there is evidence that markets react positively when politicians signal their seriousness by going against their partisan inclinations. In other words, the most credible spending reductions are those that are undertaken by left-of-center governments. So slash away, Mr. Obama!

photo by: 401K/Flickr

I summarized these issues in this summary and in this presentation.

Given what we know about austerity, my advice to the UK would be: tweak your austerity measures so that they are more spending-cut-focused and less revenue-increase-focused. And go after the most politically-sensitive items. I wish I knew more about what they actually did, but my knowledge of this is limited and I’ve frankly heard conflicting reports (apparently in the UK, there are just as many arguments over the proper baseline as there are here in the U.S.!).

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*Most of the following papers directly test the question of whether spending-cut-focused reforms or tax-cut-focused reforms are more successful and more expansionary. A few test related questions but provide corroborating evidence for this question. All of them suggest that spending-cut-focused reforms work better and are more likely to aid the economy. The papers are in chronological order, but I’d recommend starting with the latest:

Francesco Giavazzi and Marco Pagano, “Can Sever Fiscal Contractions Be Expansionary? Tales of Two Small European Countries,” NBER Macroeconomics Annual, (Cambridge, MA: MIT Press, 1990), 95-122.

Alberto Alesina and Roberto Perotti, “Reducing Budget Deficits,” 1994-95 Discussion Paper Series No. 759 (1995);

Alberto Alesina and Silvia Ardagna, “Fiscal Expansions and Adjustments in OECD Countries,” Economic Policy, No. 21, (1995): 207-47;

Francesco Giavazzi and Marco Pagano, “Non-Keynesian Effects of Fiscal Policy Changes: International Evidence and the Swedish Experience,” Swedish Economic Policy Review, Vol. 3, No. 1 (1996): 67-112;

John McDermott and Robert Wescott, “An Empirical Analysis of Fiscal Adjustments,” International Monetary Fund Staff Papers, Vol. 43 (1996): 725-753;

Alberto Alesina and Roberto Perotti, “Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects,” NBER Working Paper 5730 (1997);

Alberto Alesina, Roberto Perotti, and Jose Tavares, “The Political Economy of Fiscal Adjustments,” Brookings Papers on Economic Activity (1998);

Alberto Alesina and Silvia Ardagna, “Tales of Fiscal Adjustment,” Economic Policy, Vol. 13, No. 27 (1998): 489-545;

Roberto Perotti, “Fiscal Policy in Good Times and Bad,” The Quarterly Journal of Economics, Vol. 114 (1999): 1399-1436;

Juergen von Hagen and Rolf Strauch, “Fiscal Consolidations: Quality, Economic Conditions, and Success,” Public Choice, Vol. 109, No. 3-4 (2001): 327-46;

Alberto Alesina, Silvia Ardagna, Roberto Perotti, and Fabio Schiantarelli, “Fiscal Policy, Profits, and Investment,” American Economic Review, Vol. 92, No. 3 (2002): 571-589;

Juergen von Hagen, Hughes Halite, and Rolf Starch, “Budgetary Consolidation in Europe: Quality, Economic Conditions, and Persistence,” Journal of the Japanese and International Economics, Vol. 16 (2002): 512-35;

Silvia Adrian, “Fiscal Stabilizations: When Do They Work and Why?” European Economic Review, Vol. 48, No. 5 (2004): 1047-74;

Jose Tavares, “Does Right or Left Matter? Cabinets, Credibility and Fiscal Adjustments,” Journal of Public Economics, Vol. 88 (2004): 2447-2468;

Luisa Lambertini and Jose Tavares, “Exchange Rates and Fiscal Adjustments: Evidence from the OECD and Implicates for the EMU,” Contributions to Macroeconomics, Vol. 5, No. 11 (2005);

Boris Cournede and Frederic Gonand, “Restoring Fiscal Sustainability in the Euro Area: Raise Taxes or Curb Spending?OECD Economics Department Working Papers, No. 520 (2006);

Stephanie Guichard, Mike Kennedy, Eckhard Wurzel, and Christophe Andre, “What Promotes Fiscal Consolidation: OECD Country Experiences,” OECD Economics Department Working Papers, No. 553 (2007);

OECD, “IV. Fiscal Consolidation: Lessons from Past Experience,” in OECD Economic Outlook, 2007;

Andrew Biggs, Kevin Hassett, and Matthew Jensen, “A Guide for Deficit Reduction in the United States Based on Historical Consolidations That Worked,” AEI Economic Policy Working Paper No. 2010-04, (2010);

Ben Broadbent and Kevin Daly, “Limiting the Fallout from Fiscal Adjustment,” Goldman Sachs Global Economics Paper, No. 195 (2010);

David Leigh, Pete Devries, Charles Freedman, Jaime Guajardo, Douglas Laxton, and Andrea Pescatori, “Will It Hurt? Macroeconomic Effects of Fiscal Consolidation,” in World Economic Outlook: Recovery, Risk and Rebalancing (Washington, DC: International Monetary Fund, 2010);