The Boom Not The Slump: The Right Time For Austerity
“The boom, not the slump, is the right time for austerity at the Treasury.”
- John Maynard Keynes (1937) Collected Writings
Should the United States cut its deficit in the short term? This has been the subject of intense debate among politicians, policy analysts and thinkers over the past year. What are the consequences of cutting the deficit with interest rates low, unemployment high and growth uncertain?
A recent paper by Alberto F. Alesina and Silvia Ardagna (2009), “Large Changes in Fiscal Policy: Taxes Versus Spending” (henceforth A & A), looks at a cross section of deficit reduction policies among different countries. It examines examples where large-scale deficit reduction is associated with economic expansion and where the debt-to-GDP ratio falls in the medium-term (3 years after the adjustment). Based on this research, many popular commentators suggest that the U.S. can adopt such a policy and grow.
However, upon a further examination of the data such a conclusion is unmerited. The overwhelming majority of the episodes used by A & A did not see deficit reduction in the middle of a slump. Where they did, it often resulted in a decline in the subsequent growth rate or an increase in the debt-to-GDP ratio. Of the 26 episodes that they identify as ‘expansionary’, in virtually none did the country a) reduce the deficit when the economy was in a slump and b) increase growth rates while reducing the debt-to-GDP ratio. The sole example not covered by those two qualifiers can be explained by a combination of two policy maneuvers that are not easily available to the U.S. at the moment: currency depreciation and interest rate reduction.
- Countries historically do not cut their deficits in a slump, instead addressing these problems during a non-recessionary time.
- When countries cut in a slump, it often results in lower growth and/or higher debt-to-GDP ratios. In very few circumstances are countries able to successfully cut during a slump, and this happens only when either interest rates and/or the exchange rates fall sharply.
- In our analysis, we find that there is no episode in which a country facing the same circumstances as the United States (recent recession, low interest rates, high unemployment) has cut its deficit and succeeded in reducing its debt through growth.
- We conclude that there is little evidence provided by A & A that cutting the federal deficit in the short-term, under the conditions the United States currently faces, would improve the country’s prospects. It may even make the United States’ situation far worse.