Tag Archives: OECD

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.

The Government (Un)employment Effect

A few hours ago, the Obama Administration released a new report estimating that Stimulus II saved or created about 3 million jobs. Shortly thereafter, my colleague, Veronique de Rugy, testified before Congress on the impact of the stimulus. She argued, among other things, that more realistic estimates show that fiscal stimulus tends to do more harm than good.

All of this talk about jobs reminds me of one of Veronique’s recent posts:

Since the beginning of the recession (roughly January 2008), some 7.9 million jobs were lost in the private sector while 590,000 jobs were gained in the public one. And since the passage of the stimulus bill (February 2009), over 2.6 million private jobs were lost, but the government workforce grew by 400,000.

I will leave it up to you to draw conclusions.

In the spirit of drawing conclusions: one body of research suggests that the conclusions are not happy ones. A number of studies have examined the relationship between government employment and private employment, concluding that the former crowds out the latter. Using data from 19 countries over 17 years, Horst Feldmann (2006), for example, examined the relationship between a large government sector and unemployment. He found:

[A] large government sector is likely to increase unemployment. It appears to have a particularly detrimental effect on women and the low skilled and to substantially increase long-term unemployment.

What is more, Feldmann is not the only one to come to this conclusion. As he reports in his literature review:

Several empirical studies suggest that an increase in government expenditure impairs labor market performance. For example, Karras (1993) observed negative employment effects of government spending in eight countries in his sample of 18 countries. Yuan and Li (2000) came up with the same result for the US. In a cross-country study of 15 major industrial countries, Abrams (1999) found that the government expenditure ratio was positively related to the unemployment rate. Christopoulos and Tsionas (2002) examined the relationship between the government expenditure ratio and the unemployment rate for 10 European countries over the period 1961 to 1999 and found that there was unidirectional causality from government size to unemployment rate.

The magnitude of the government (un)employment effect is not trivial. Looking at a sample of OECD countries for 40 years, Algan, Cahuc, and Zylberberg (2002) found that the “creation of 100 public jobs may have eliminated about 150 private sector jobs”