In an interview with the Wall Street Journal, Council of Economic Advisers Chairman Alan Krueger suggested that the coming “sequester” would deal a harmful blow to the economy. Specifically, Krueger argued that international evidence indicates “cutting government spending too early during a recovery slows economies dramatically.” This claim is at best misleading on two counts: First, we’re actually quite “late” in the recovery in terms of time elapsed since the end of the recession. It only feels “early” because the pace of growth during the recovery has been so slow. Second, the international evidence strongly cautions against the Obama Administration’s economic policies, as deficit reduction based on tax increases tends to be much more debilitating than spending cuts. Spending cuts tend to boost private investment, which partially or wholly offsets the direct effect of the cuts.
Between 1854 and 2009, the average U.S. recovery (trough of the recession to the new business cycle peak) lasted 42 months, which happens to be precisely the time since the recovery began in July 2009. By historic standards we’re extremely late in the recovery. Krueger confuses the time dimension of the recovery – i.e. months since the trough of the recession – with the qualitative dimension concerning the extent to which the recovery has recouped lost output. Key metrics like the employment-to-population ratio remain stuck at a 30-year low, which means we’ve experienced very little in the way of true recovery. But Krueger is misleadingly referring to the inadequacy of the recovery to date when he claims we’re “early” in the recovery.
Krueger’s claim about the international evidence regarding the economic harm of spending cuts makes little sense given the Administration’s campaign for tax increases. The bulk of evidence on the economic effects of fiscal consolidation suggests that tax increases are far more damaging than spending cuts and that tax increases in “incomplete” fiscal adjustments are generally the most toxic of all. This is precisely the Obama Administration’s approach: increase taxes whenever possible in the context of a wholly inadequate deficit reduction package.
The basic finding from the literature is that the economy contracts in most cases of fiscal consolidation. Spending cuts and tax increases tend to cause the economy to slow in the very short run. This is not surprising: tax increases and spending cuts reduce disposable income and government purchases of goods and services. If all else were equal, fiscal consolidation would always result in a smaller economy. But all else is not equal; more careful research that distinguishes between deficit reduction done through tax increases and that accomplished through spending cuts has found that spending cuts are much more efficient because they lead to offsetting increases in private investment.
The basic finding is not that spending cuts always and everywhere boost growth – as has been mischaracterized by many critics – but rather than spending cuts are associated with short and shallow recessions, while tax increases tend to be associated with longer and deeper recessions. A recent IMF study confirms this finding, with the impact of tax increases on GDP three-times as great as spending cuts (–1.3% compared to –0.43% for spending cuts). And in some circumstances, the offsetting increase in private investment can be so great that spending cuts actually boost growth rates.
Interestingly, the larger the spending cuts, the more beneficial the effects tend to be. A highly credible shift to a balanced budget regime based on large spending cuts has been found to generate large economic gains. Smaller, incremental approaches generally fail to generate the confidence gains and investment than offset the contractionary effects of the decline in disposable income or government purchases. The key is for the government to signal its intention to close the fiscal gap and then pursue spending cuts on a scale necessary to achieve it. This action causes households and businesses to reduce expectations of future tax increases, which results in higher estimates of future income and profitability that boosts investment today.
Again, whatever one’s view on whether deficit reduction could boost short-run growth, empirical research is nearly unanimous that spending cuts are less harmful than tax increases. Papers that reach different conclusions tend to ignore actual data and rely instead on models of how the world should work under different assumptions. Interestingly, a recent theory paper that predicts large government spending multipliers gets the same results whether the increased government spending is financed through tax increases or deficits. The suggestion that trillions of dollars of new spending and tax increases is the key to economic recovery depends on some very suspect assumptions and has virtually no basis in actual human experience.
The Obama Administration continues to believe that the focus on deficit reduction is a sideshow that distracts from its robust policy agenda. Yet, without a comprehensive solution to the fiscal imbalance, the economy is unlikely to gain the traction necessary to allow the focus to shift to other issues. The short-run pain of the sequester is likely to be smaller than that of the tax increases, despite being larger in dollar terms. Rather than ending the sequester or replacing it with tax increases, policymakers should dramatically increase its size to boost confidence and private investment.