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The case for austerity, and our case

In recent months, economist Alberto Alesina has become popular among conservatives for research showing that deficit reduction can sometimes be accompanied by economic growth; that spending cuts are better than tax cuts; and for arguing that stimulus is less effective than Keynesians think and thus spending cuts can begin now. Business Week's Peter Coy is skeptical:

Alesina's historical research, though, doesn't shed much light on what might happen if the U.S. adopts an austerity budget, because current circumstances don't resemble most of those in Alesina's database. It's rare for a nation to suffer such a big shortfall in demand that it cuts interest rates to zero, as the U.S. has. It's even rarer for a government in such circumstances to tighten its fiscal belt. Japan's experience is a cautionary tale. Japan attempted to tackle its deficit in the late 1990s during a period of weak demand and near-zero rates. Many economists say the move prolonged the slump that became known as Japan's Lost Decade. To be sure, Japan tried to balance its budget mainly by raising taxes, which is not Alesina's preferred solution.

Economists who describe themselves as Keynesians or neo-Keynesians don't buy Alesina's medicine. Gauti B. Eggertsson, a staff economist at the Federal Reserve Bank of New York, concluded in a paper last November that, with interest rates at zero, the right remedy is to raise government spending, not cut it. Espousing his own views and not those of the Fed, Eggertsson wrote that when extremely loose monetary policy isn't stimulative enough, "the goal of policy should be to increase aggregate demand -- the overall level of spending in the economy."

Alesina's own research shows mixed results from deficit-cutting. He identified 26 examples since 1980 of deficit reductions that triggered growth of gross domestic product and 21 that lowered government debt substantially. He found only nine double victories in which government policymakers managed both to expand their economies and reduce debt. (Among them: Ireland in 2000, and the Netherlands and Norway in 2006).

To argue with myself for a moment, this is one of the difficulties with analysis. Fairly few political commentators know enough to decide which research papers are methodologically convincing and which aren't. So we often end up touting the papers that sound right, and the papers that sound right are, unsurprisingly, the ones that accord most closely with our view of the world. So Alesina's paper gets a lot of conservative pickup, but if it had found the opposite, it would've been ignored by conservatives, or maybe torn apart by experts sympathetic to the conservative approach to austerity, even as liberals championed its findings.

That said, even as a matter of simple logic, I really don't understand the case for why a business would begin spending if the government announces major cuts this year. So the government says, "I'm going to take demand out of the market, end tax cuts that are helping people spend, throw a large number of public employees out of work, and reduce the spending power of the unemployed." And it's in that context that, say, a manufacturer of picture frames, or a local coffee chain, decides to hire more people? Where is the promise of further demand?

By Ezra Klein  |  July 7, 2010; 9:00 AM ET
Categories:  Budget  
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Next: Outlining the stimulus and deficits debate

Comments

exactly! There's no rational case for austerity helping the US, barring severe currency devaluation. And I doubt we'll hear many conservatives talk about sinking the dollar. This is straight out of the Herbert Hoover playbook.

Posted by: Quant | July 7, 2010 9:15 AM | Report abuse

Austerity is a starvation diet. Keynesian stimulus of the levels demanded by the Krugman's of the world is a glutton's feast. The answer to an excess of debt-creating gluttony is not more of the same. However, starvation isn't the answer, either. A healthier diet and exercise--the boring, slow-moving answer nobody wants--is probably the best strategy.

And if government expenditures had been put on a diet in the countries now taking the austerity approach, they wouldn't have be starving now, and it wouldn't be such a shock to the system.

Plus, even if austerity is ultimately a very, very positive thing, the immediate shock is clearly going to be destructive, and it could take many months and even years for any positive benefits to accrue. I think the government's taking the extreme austerity approach are going to have to expect to be tossed out in the next election cycle. Even if it is the right thing to do (which I do not know), it's clearly a very hard thing to do, and, historically, politicians do not get rewarded for anything "hard", right or not.

Posted by: Kevin_Willis | July 7, 2010 9:33 AM | Report abuse

That said, even as a matter of simple logic, I really don't understand the case for why a business would begin spending if the government announces major cuts this year


I agree with you there Ezra but WHY would businesses increase spending in an atmosphere where government is increasing regulation (no matter how necessary), taxes and is as openly anti-business and pro labor as this one is (especially in comparison with the last administration). You've gone from one polar opposite to close to the other and expect businesses to go crazy spending on a whim. Sorry its not going to happen. That's why you're seeing businesses horde cash.

As I saw somewhere else you can force them to provide healthcare and you can force them to pay higher taxes but you can't force them to employ more people. As stated many times over employers will work current employees to the max before hiring new ones.

Posted by: visionbrkr | July 7, 2010 10:07 AM | Report abuse

An answer to the question "I really don't understand the case for why a business would begin spending if the government announces major cuts this year" might begin with the answers to question posed in The Economist and cited in Reconciliation yesterday.

The government pays for nothing; that is, every dollar of government spending is a dollar stolen from the pocket of some taxpayer. When the government is spending but is unsure whose pocket will be picked, all taxpayers (including businesses) must reduce spending as a matter of future survival: by deferring choice of its tax victim, the government implicitly requires all potential victims to spend less. Moreover, the potential tax victims who do spend in times of regulatory and tax uncertainty know either that they have no assets worth victimizing, can successfully transfer the victimization to others less powerful, or can outrun the catastrophe (by corporate death or by shifting of assets beyond the reach of taxation). So, unworthy businesses become the golden spenders, favored by the government yet effectively out of its tax reach, while honest businesses thoughtfully reduce payrolls and other expenses... the too-big-to-fail world expands!

Again, there is no such thing as a government dollar: there are only government-collected taxpayer dollars.

Posted by: rmgregory | July 7, 2010 10:18 AM | Report abuse

Government spending is not only the best way out of the demand deficit; it’s the only way out.
The question is what spending?
Certainly aid to states to ward off “rif”-ing cops, teachers, firefighters, and other providers of essential services is essential.
So is extending unemployment insurance and tax reductions for middle class earners.

But surely that alone is not enough.

What ever happened to all the infrastructure stimulus money?
Sure, some has been used, but in Greater Boston, roads are still crumbling and bridges are either closed or still look dangerously rusty. There are big, bold signs that say it’s being used, but there’s no evidence of roadwork going on (see I93 / I95 (128) intersection, north of city).
Sure, there’s been some talk of commuter rail improvement, but it’s really just more of the same old same old. Tiny incremental improvements to an old and antiquated system leads to no more frequent service, no faster trains, no additional intermodal options.
Sure, Amtrak has finally gotten enough to begin planning high speed rail throughout Chicago-land, Southern and Central Florida and a few other corridors, but even this is hardly sufficient. At last, we’re beginning to execute a plan that’s been in play in Europe and Japan for more than 40 years and now in China,

There is so much that can be done.
The Acela is America’ the closest thing we have to a high speed train and it’s net speed is restricted to about ½ its rated cruising speed mostly due to ancient right of way.
(In fact a new route through Worcester, Springfield and Hartford should be created for the real express.)
If it averaged 110 MPH throughout the run from Boston to New York, the trip would take no more than 2 hrs.
It would be the one fastest way from down town to downtown, bar none.
No one would fly in the shuttle again.

This is one single smallish example.
What would a larger, more ambitious stimulus do?
Imagine replicating and improving that average speed in and around Chicago, between LA and SF (and Portland and Seattle), between Houston, Austin, San Antonio and Dallas.
In many areas speeds could be significantly higher.

Stop thinking Toonerville Trolley.
Start thinking Apollo .

Posted by: bobwatts | July 7, 2010 10:22 AM | Report abuse

--"Where is the promise of further demand?"--

There are no guarantees, Klein. But creating faux-demand via "stimulus" is just sleight of hand that wastes future value. As long as you keep stealing from people to create fake spending you will stifle real demand (real demand being the trading of one's assets that one earned oneself.) Getting government out of the distorting-the-markets game will clear the deck of numerous uncertainties and give businesses a real place from which to plot their futures. The "promise of further demand" is meaningless gobbledegook (Klein's essence). Businesses will wait for the actual demand to show up, and not the fake demand of government distributing stolen goods.

Posted by: msoja | July 7, 2010 10:24 AM | Report abuse

Exactly! The promise of future demand is implicit in a government whose hands are out of taxpayers' pockets; that is, by agreeing (even momentarily) to refrain from stealing my money tomorrow, the government allows me to plan for today... to spend in a manner most to my liking without fear.

Posted by: rmgregory | July 7, 2010 10:51 AM | Report abuse

"And it's in that context that, say, a manufacturer of picture frames, or a local coffee chain, decides to hire more people? Where is the promise of further demand?"

I'll give this a good faith effort, even though the facts lead me to agree with Ezra.

The assumption here is that conservative small business owners are rational economic actors. In my experience, the conservative ideology trumps the macroeconomic numbers for small business owners. Given a "win" on budget austerity or de-regulation, they would feel more optimistic about the future and more likely to hire, invest in the business, etc. I don't believe that small business owners take their cues from economists, at least not nearly as much as say, Rush Limbaugh. Just as they feel stymied with the current Democratic control of government; the feeling of empowerment will loosen the budget strings.

This may be an unfortunate dynamic, but it's something to consider.

Posted by: danimal1 | July 7, 2010 11:28 AM | Report abuse

"...I really don't understand the case for why a business would begin spending if the government announces major cuts this year..."

Ezra - read Matrin Wolf's latest column in Financial Times. He is grappling with $3T excess cash with Private Sector Businesses in Advanced countries and impact of that.

What it means is Businesses saved money even when recession was there. Standard argument is exports to China, India, other emerging markets and residue demand in OECD even after recession. So I am not sure people are worried about demand for Private Businesses, at least at aggregate and larger scale.

In other words do not go on justifying deficit spending to create demand for Private businesses.

True demand for sure gets created when Government spends, but it is more for employment generation so participation of 'actors' in Economy increase rather than existing players getting more demand. That is a side effect in some sense.

Posted by: umesh409 | July 7, 2010 11:46 AM | Report abuse

visionbrkr: "WHY would businesses increase spending in an atmosphere where government is increasing regulation (no matter how necessary), taxes and is as openly anti-business and pro labor as this one is (especially in comparison with the last administration). You've gone from one polar opposite to close to the other..."

I think these assumptions are just incorrect. First, if regulation is "necessary," then isn't it a good thing in the long term? Second, I haven't heard anyone talk about major immediate tax hikes, except for possibly allowing the Bush tax cuts for the wealthy expire (which would merely return them to the Clinton rates). Labor legislation has gone nowhere, and given that unions make up only 7 or 8% of the private workforce, it's hard for me to believe that they're a major inhibiting factor on economic growth.

I agree with the view that there is no contradiction between short-term spending to improve the economy with long-term fiscal responsibility. One could even argue that the prospect of higher taxes in the future (which most number-crunchers see as inevitable) could induce more business spending now to take advantage of today's rates before they go up.

Posted by: dasimon | July 7, 2010 12:01 PM | Report abuse

"So we often end up touting the papers that sound right, and the papers that sound right are, unsurprisingly, the ones that accord most closely with our view of the world."

You just defined George Will's career.

Posted by: JamesCody | July 7, 2010 1:35 PM | Report abuse

We have a problem with the fiscal stimulus model, Y = I + C + G, in our 'new economy'. We now have so much international trade that the feedback loop is highly dependent on the willingness of our trading partners to buy from us using the stimulus dollars we send them from our purchases of their goods and services. Given the Chinese propensity to for surpluses, we get a lot of leakage in our international trade with them, which means that every additional dollar we spend with them doesn't result in an additional dollar of spending with us. This means we lose a lot of the multiplier effect in the model.

In addition, the model works only when the propensity to hoard (save) is not adversely impacted by government spending and when the borrowed or taxed funds can be distributed to people who will not hoard. What if the propensity to hoard money is now being increased by more government spending? What if the fear of government deficits is so strong now that many people want to save more than spend now so that they can have more funds for spending in the future when they think they will have less money due to unemployment or higher taxes? In that situation, action must be taken now to reduce the deficit so that people will hoard less while also taking steps to stimulate the portions of the economy that can multiply employment. In short, we would need to substantively cut non-productive government spending and moderately increase productive government spending.

What would be productive government spending? It would be the spending that has significant impact for improving productivity in the private sector. One past example would be the internet spending that allowed companies to create software linkages that reduced inventory and sped the flow of good and services to consumers. Another could be adding distributed electric generation that increases capacity without increasing requirements for long-distance transmission lines. Another could be creating a medical system that focuses more on keeping most people working or in school and less on taking care of the few that have major illnesses. Another could be a refocusing our schools so that they spend most of their efforts ensuring that everyone can work and live productively by the time they are 16 and only focuses on college prep for those who are older than 16.

None of these investments will have immediate direct impact on employment, of course. But, combined with major cuts in the non-productive services that people know will cut the deficit, they will have a direct impact when people become more positive about the future and, thus, more willing to spend now.

Of course, reducing non-productive government services means there will be a lot of pain among some voters. But is there any other way if the propensity to hoard is tied to the people's concern about the deficit?

Posted by: JDeFoor | July 7, 2010 4:30 PM | Report abuse

You forget that the owner and manufacturer were living in abject fear of what confiscatory policy the government planned to implement next. Now that the government has committed to a policy of retrenchment, our manufactures and owners can go back to being the Randian Super Capitalists they were before the parasites got involved.

Do you know nothing, Ezra?

Posted by: zosima | July 7, 2010 10:25 PM | Report abuse

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