The Broader Market

Alberto Alesina, a Harvard economics professor, has been making the case that spending cuts and tax increases generate economic growth.  In a paper presented to the European Union’s economic and finance ministers in April of this year, Alesina made the argument that large spending cuts, sufficient to reduce budget deficits, have often been followed by economic growth.  He writes:

Current increases in taxes and/or spending cuts perceived as permanent, by removing the danger of sharper and more costly fiscal adjustments in the future, generate a positive wealth effect.

An additional channel through which current fiscal policy can influence the economy via its effect on agents’ expectations is the interest rate. If agents believe that the stabilization is credible and avoids a default on government debt, they can ask for a lower premium on government bonds. Private demand components sensitive to the real interest rate can increase if the reduction in the interest rate paid on government bonds leads to a reduction in the real interest rate charged to consumers and firms. The decrease in interest rate can also lead to the appreciation of stocks and bonds, increasing agents’ financial wealth, and triggering a consumption/investment boom.

Alesina’s central assertion is that spending cuts calm bond markets and stimulate private investment.  As the government begins to shore up its balance sheet, both investors and consumers will be reassured that further, more painful measures will not be necessary in the future.  Investors will be less concerned of sovereign default, which will lower the risk premium (higher interest payments) they demand on US government bonds.  This will generate a reduction in the real interest rate, which will be a boon for consumers and firms alike who can now borrow and finance their activities at cheaper rates.  Consumers, confident in the actions of their government, will resume spending, which should stimulate economic activity and investment.

The theoretical and empirical arguments presented by Alesina appear to be internally correct.  However, the contention that many Keynesians may have with Alesina has little to do with his historical research.  Rather, it is the policy lessons Alesina draws from his empirical findings that generates disquiet among Keynesian economists.  Alesina’s assertion that spending will trigger economic growth in the United States is troubling because his research does not cover the kind of economic conditions that we presently find ourselves in.  Interest rates are already near zero in the United States and investors continue to buy US Treasuries at high prices and low interest rates.  In this sense, tighter fiscal policy would not be able to generate the kind of rewards that Alesina mentions above.  Furthermore, the recent austerity measures in Greece have hardly brought about the benefits of lower borrowing costs promised by Alesina.

It should also be noted that in many countries that saw both growth and deficit and debt reductions, such as Canada in the 1990s, additional factors seem to have offset austerity measures to create economic growth.  In Canada, the loonie depreciated substantially to allow the country to generate export led growth, while also reducing its structural deficit.  With the US economy experiencing a liquidity trap and the government with few monetary tools at its disposal, it is hard to see how devaluation would occur.  Furthermore, the kind of devaluation that occurred in Canada would require our trading partners to let their currencies appreciate against the US dollar.  In a period of high unemployment in many developed economies, it is hard to see how this could be achieved.  Thus, austerity may not be the magic bullet Alesina supposes. 

The arguments presented by those in the pro-austerity camp can be persuasive.  Indeed, many are certain that spending cuts are the correct policy choice right now.  However, the argument that cutting spending will avert a future debt crisis in the United States seems to miss the point that government revenue comes primarily from tax payments from the employed.  Thus, it is hardly accurate to implement a policy that will increase unemployment and simultaneously claim that the policy will reduce government debt levels.  It may be counter-intuitive to suggest that spending cuts will increase US government debt levels.  Counter-intuitive or not, it does not make it any less true.