Can Austerity Increase Economic Growth?

A loyal reader asks if cutting government spending could possibly help create jobs. He's skeptical. The short answer is austerity does not help the economy in the usual Keynesian models--but there's reason to doubt them.

Here's a short lesson in the history of economic thought. John Maynard Keynes developed a theory that found government spending could significantly boost or contract the economy. That became part of the established body of economic thought.

Early critis of Keynes argued that he had not fully considered "crowding out" whereby government borrowing pushes up interest rates, crowding out private sector (and especially corporate) borrowing, leading to reduced investment in capital equipment. Actually, Keynes had addressed the issue and decided that when sales are very low, companies are hesitant to expand capacity at any interest rate.

Other challenges to Keynes came from the monetarist school, led by Milton Friedman, which didn't attack the theory so much as say that money had a much larger impact on the economy than did government policy. This view became the established theory in the 1980s and 1990s (and I'm simplifying tremendously).

A frontal assault on government spending as a stimulus came from a great modern economist, Robert Barro (who has been named as a possible Nobel laureate). Barro argues that taxpayers anticipate future tax bills. When they see large deficits, they assume they'll eventually have to pay the bill. They cut spending now to build up reserves to cover their future tax liability. This idea was first posited by the great 19th century economist David Ricardo.

Immediately after Barro published the theory, which we call Ricardian Equivalence, I laughed. "Yeah, people are that rational that they figure out their future taxes years in advance. Ha ha ha."

I'm not laughing to hard now. Here's what I'm saying in my speeches: The deficit is huge. It may improve a little with economic growth, but then the boomers start retiring, collecting Social Security. And they get Medicare. Then new hips, knees, hearts, etc. Over time, deficits continue to expand. (The social security component at least levels out as a share of GDP, but Medicare continues to worsen as health care inflation and utilization rates continue to push costs beyond revenues.)

I do not expect the Federal Reserve to allow enough inflation that the debt is effectively repudiated. And I do not expect the government to officially repudiate the debt, as some Latin American countries have done. Instead, I expect that taxes will rise. There may also be some entitlement reform, but most of the deficit cutting will come from higher taxes.

In my speeches on the economic outlook, I predict higher taxes in the coming decade, and I advise audiences to save more. Their nest eggs will produce fewer after-tax spendable dollars when tax rates rise, so larger nest eggs are needed.

I am advising people to follow that theory I laughed at: spend less now because taxes are going up.

The calculation of future tax burdens is not at all formal or precise. It's a gut feeling. And I think it is truly at work, especially among middle and upper income families. I hear it a lot from people I speak to.

That's how cutting government spending can help jobs. People would like to feel confident that the government is operating prudently, responsibly. I doubt that anyone, left or right, would use those words right now.

 

Comments

[Jesse]

"I do not expect the Federal Reserve to allow enough inflation that the debt is effectively repudiated. And I do not expect the government to officially repudiate the debt, as some Latin American countries have done. Instead, I expect that taxes will rise. There may also be some entitlement reform, but most of the deficit cutting will come from higher taxes."

I think the ideological thought that the Fed can keep inflation in check is naive. Sure, the Fed can pump excess liquidity into circulation which allows people to live beyond their means through cheap credit that they never can pay back and with that we "solved" another recession by creating the next (housing) bubble. But doing so doesn't solve our fundamental economic problems, it only delays the inevitable crash and exposure of what the US Economy has become.

I don't think that the Fed has the ability to keep inflation in check when that time comes. Sure, as long as the USD is the World Reserve Currency the US and the Fed can greatly abuse their position and power as they can get away with it. The Fed can manipulate not only the short term rates but also the long term through the Fed Bond Purchase Program as it creates debt out of thin air. But what can the Fed do when foreigners no longer accept the USD as a means to settle international trade? It's already starting to take place as China and Russia settle their trade in non-USD currency. If the world loses confidence in the USD price inflation on imports could instantly reach hyperinflationary levels and our ability to finance our deficit spending addiction through the debasing of the currency which is financed through foreign USD investment would also come to a halt. There's not much the Fed can do then and I think it's naive to disregard the many monetary lessons of history and naively assume that the US is somehow except from having the USD collapse through hyperinflation .

The theory that government can solely stimulate the economy through deficit spending is also very short sighted in my opinion. By not allowing recessions to unfold we never allow the economy to have a healthy contraction, we never allow the economy to cleanse itself. Instead the interventionist policies of both Fed and Government encourage more of the same while propping put the financial irresponsible and making it more difficult for the sound business practices to survive. Such interventionist economic policy sure give the illusion that it works as we avoid recessions and never have any significant contractions in the economic cycle. But we don't do so by solving the underlying economic problems but instead we mask the symptoms of the problem by continuing to create a problem of greater proportions. We solved the recession following the dot come bubble by creating the RE bubble, then we re-inflate that with more bailouts to encourage spending, etc. I forecast that ultimately this system will collapse and the US economy no longer viable will be exposed for what it is as we currently are faking our "economic report card" through major Government deficit and consumer credit spending. We're in a major GDP Bubble !

I agree with you that ultimately we'll pay for all this through taxes but I'd make the point that this tax will be the "hidden" tax of inflation and ultimate hyperinflation .