Tag Archives: Alberto Alesina

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);

 

 

Can a reduction in government spending stimulate the economy?

This, of course, is quite relevant given the latest news. To help find the answer, I consulted my graduate macroeconomics text. There, on pp. 546-7, I found this passage:

[A] small reduction in current government purchases could signal large future reductions, and therefore cause consumption to rise by more than the fall in government purchases.

Surprisingly, these possibilities are more than just theoretical curiosities. Giavazzi and Pagano (1990) show that fiscal reform packages in Denmark and Ireland in the 1980s caused consumption booms, and they argue that effects operating through expectations were the reason. Similarly, Alesina and Perotti (1997) show that deficit reductions coming from cuts in government employment and transfers are much more likely to be maintained than reductions coming from tax increases, and that, consistent with the importance of expectations, the first type of deficit reduction is often expansionary while the second type usually is not.

I did my graduate work at George Mason, so you may be thinking that this is some free-market fundamental text. It is actually David Romer’s Advanced Macroeconomics (David, of course, is the husband of President Obama’s former CEA chair, Christina Romer).

Since Mr. Romer wrote the passage above (the second edition was published in 2000), the case for expansionary spending cuts has, if anything, strengthened. Consider this 2010 piece by Harvard’s Alberto Alesina. He finds:

[N]ot all fiscal adjustments cause recessions. Countries that have made spending adjustments to reduce their deficits have made large, credible, and decisive cuts. Even in the very short run, many reductions of budget deficits, even sharp ones, have been followed immediately by sustained growth rather than recessions.

Or consider this 2010 piece by David Henderson. It focuses on the Canadian experience of cutting spending in the 1990s. He writes:

Canada was able to escape from chronic deficits and trimmed its debt from nearly 70 percent of GDP to 29 percent of GDP, all without sacrificing growth.

What’s more, “There were six to seven dollars in budget cuts for every dollar of tax increases.”

Or consider another piece, also by Henderson, focusing on post-WWII spending cuts in the U.S. He writes:

In the four years from peak World War II spending in 1944 to 1948, the U.S. government cut spending by $72 billion—a 75-percent reduction. It brought federal spending down from a peak of 44 percent of gross national product (GNP) in 1944 to only 8.9 percent in 1948.

The post-WWII U.S. economy is widely regarded to have been quite healthy. This, of course, confounded Keynesians like Paul Samuelson who had predicted that war demobilization would lead to the “greatest period of unemployment and industrial dislocation which any economy has ever faced.” (emphasis original)

Or try this 2010 piece by Goldman Sachs economists Ben Broadbent and Kevin Daly. They report:

In a review of every major fiscal correction in the OECD since 1975, we find that decisive budgetary adjustments that have focused on reducing government expenditure have (i) been successful in correcting fiscal imbalances; (ii) typically boosted growth; and (iii) resulted in significant bond and equity market outperformance. Tax-driven fiscal adjustments, by contrast, typically fail to correct fiscal imbalances and are damaging for growth.

In contrast, some people are pointing to a new IMF report that claims “fiscal consolidation typically reduces output and raises unemployment in the short term.” But as Alberto Alesina argues, the IMF findings are not all that different from his own. Critically, the IMF agrees that “tax increases are much worse for the economy than spending cuts.” Moreover, the IMF agrees that “after a few years, even large (but spending based) fiscal adjustments create growth for the economy.”

To me, the evidence suggests that Obama’s Deficit Commission chairs are on the right track in emphasizing 75 percent spending cuts relative to 25 percent revenue increases.