The American people seem to be in a mood to “compile additional data.” A friend of mine, an old hand in Alcoholics Anonymous, uses that phrase to describe early phases in his recovery when he would relapse into heavy drinking. After a few such periods of “compiling additional data” on his powerlessness over alcohol, he eventually got it right and has been sober for years.
Many people apparently believe that if only the federal government reduced spending, the economy would perk up and everything would be hunky-dory. I am doubtful, and so are a great many other economists, including many skeptics about using taxes and spending to control the business cycle. However, people are not paying much attention to what economists think right now. It seems the nation is bent on “compiling additional data” about unsustainable policies.
At least rhetorically, there is mounting support for sharp cuts in spending here in our own country. In Europe, the current British government was elected on a platform of spending cuts and tax increases. There are similar calls for austerity on the continent itself and eurozone authorities are pressing Greece and other countries with severe debt problems to make drastic spending cuts and implement tax increases.
The problem is, history demonstrates that austerity measures like these tend to slow economic output and increase unemployment for extended periods. There also is much economic theory that predicts this will happen. Indeed, the Keynesian ideas that have driven most applied policymaking in industrialized countries over the past 60 years are based on the premise that increases in spending coupled with cuts in taxes can increase output when an economy has slack capacity – in other words, when unemployment is high. In this view, cuts in spending and increases in taxes not only slow an overheated economy, but can further slow one already in the doldrums.
Although this thinking still drives policy in most countries, it no longer represents a consensus among economic theorists. In particular, the school of economic thought variously termed “rational expectations,” “New Classical” or “Modern Macro” argues that Keynesian efforts to control the business cycle with fiscal and monetary policy are at best ineffectual and at worst counterproductive.
Despite this difference among theorists on the wisdom of Keynesian policies, the practical fact remains that both lower spending and higher taxes, even when there is no other alternative, tend to slow production and increase unemployment, at least for some time.
The link between fiscal austerity and economic slowing is crucial in Greece, where economic performance has worsened following spending cuts and tax increases demanded by eurozone officials as the price of the initial bailout measures in 2010.
The problem for Greece is that it has little choice. It will have to cut spending and increase taxes to get assistance from the rest of the eurozone and the International Monetary Fund. Even if it does not get such assistance, even if it exits the euro system, Greece will have to make drastic changes to be fiscally viable.
The question is, do we face the same harsh choice?
The standard answer from Keynesians like Ben Bernanke or Paul Krugman is that we need austerity, but not quite yet. In other words, loose fiscal and monetary policies are needed to foster further economic recovery. When growth is stronger, some spending, like that for unemployment benefits and food stamps, will automatically fall. Tax revenues will rise with incomes. Then a combination of other spending cuts and tax increases can close the remaining deficit.
In the meantime, however, they say that what we need is bipartisan agreement on this future package to give markets and households greater confidence.
Given the fiscal history of the past 30 years, achieving such a bipartisan agreement that will generate widespread confidence, while continuing deficits in the short run, is a fantasy.
We are in a fix. The Obama administration seems committed to muddling through until after the 2012 elections. All Republican presidential candidates except Jon Huntsman still call for tax cuts in the face of the largest relative deficits since World War II, even though tax revenues as a proportion of GDP remain 20 percent below the levels common for most of the past 40 years. Yes, the candidates all call for large spending cuts, but none dares to specify exactly what these will be. Even the plan of non-candidate Paul Ryan, the putatively courageous spending cutter, delays difficult cuts by a decade and doesn’t offer any hope of fiscal balance in the next 10 years.
Perhaps we can muddle through, as some Keynesian economists, the president and many on Wall Street apparently hope. Perhaps some as-yet-unknown charismatic leader will forge a consensus on moderately higher taxes and sharply decreased spending that will have no short-term negative effects. And perhaps someday pigs will fly, swooping gracefully above our heads as we enjoy 3 percent unemployment and 5 percent GDP growth.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.