On February 6, John Boehner (R-OH) told reporters at his weekly press briefing, “The number one priority for the American people is creating jobs and getting our spending under control.”
The underlying assumption driving the Republican Party’s approach to the deficit is that cutting spending will increase growth and therefore create jobs. To Boehner and his Republican colleagues, thus, “getting our spending under control” and “creating jobs” are cut from the same cloth, with the former leading to the latter. But is this assumption accurate? And are these two priorities even compatible with one another?
In the short-term, the answer to that question is a resounding no. As the Tax Policy Center has noted, “[d]eficit reduction and the government component of economic growth are unavoidably opposite sides of the same coin.” While rapid fiscal consolidation is desirable to return public finances to a sustainable path, it is also a significant drag on growth. To most economists, therefore, our choices involve a “trade-off between the benefits of starting to address the debt problem earlier versus risking damage to a still-fragile economy by engaging in contractionary fiscal policy, or failure to continue with expansionary fiscal policy.”
Republicans and proponents of expansionary fiscal austerity often cite the work of Harvard University economist Alberto Alesina to justify their position. For example, Alesina and Perotti (1995) and Alesina and Ardagna (2006) purport to show that fiscal adjustments tend to be expansionary, even in the short run, when they rely primarily on spending cuts (see also Von Hagen and Strauch (2001) and Broadbent and Daly (2010)).
The applicability of Alesina’s findings to the current U.S. fiscal situation, however, is questionable.
Most of the successful fiscal adjustments identified by Alesina took place during favorable economic conditions (see the figure on the right; the U.S. during the Great Recession is represented by the three bars on the far right). Ten of the 17 successful episodes (about 60%) occurred when actual output was above potential output, and the remaining 7 cases occurred when the output gap was only slightly negative. In contrast, 9 out of 10 fiscal adjustments beginning when actual output was below potential output were unsuccessful. Therefore, as noted by the Congressional Research Service, “fiscal adjustments beginning in a slack economy (such as the current situation in the United States) appear to have a low probability of success.”
Furthermore, as the International Monetary Fund (IMF) noted, the methodology undergirding Alesina’s research is fundamentally flawed. According to the IMF, the approach used by Alesina to identify cases of fiscal consolidation biases the results toward finding expansionary effects, for two primary reasons. First, Alesina’s approach suffers from measurement errors that are likely correlated with economic developments rather than actual policy changes. Second, it ignores the motivation behind fiscal actions. Taken together, these criticisms target the methodology Alesina used to identify periods of fiscal consolidation; namely, the strategy of identifying periods of fiscal consolidation based on successful budget outcomes.
When the IMF re-examined the argument advanced by Alesina by identifying episodes of fiscal consolidation based on fiscal policy actions, irrespective of the outcomes, it came to the opposite conclusion. The IMF found that fiscal austerity is typically contractionary, with cuts in spending being less contractionary than increases in taxes. Specifically, a consolidation equal to 1 percent of GDP typically reduces GDP by about 0.5 percent and increases the unemployment rate by about 0.3 percent after two years (these results are statistically significant). Thus, the IMF concluded that “the idea that fiscal austerity stimulates economic activity in the short term finds little support in the data.”
Importantly, the IMF found that other factors can exacerbate the contractionary impact of austerity, at least two of which are applicable to the current situation in the United States. First, fiscal consolidation preceded by low perceived sovereign risk (i.e., when there is little doubt about a nation’s fiscal solvency) are more contractionary than those preceded by high perceived sovereign default risk. Second, when a nation’s interest rates are stuck at zero, the impact on GDP doubles to about 1 percent after two years. And when the rest of the world conducts fiscal consolidation at the same time that interest rates are stuck at zero, the impact on GDP doubles again, to 2 percent after two years.
The inescapable conclusion from this data is that, while there are significant long-term gains to fiscal consolidation, undertaking fiscal consolidation has negative short-term effects. And given the fact that the United States has low perceived sovereign risk and interest rates stuck at zero, these negative effects would be exacerbated.
There are countries that have successfully gone the route of fiscal austerity to boost growth. But the differences between these countries and the United States, as the Center for Economic and Policy Research has noted, “are large and are very central to the adjustment process.” The Center for American Progress estimates that fiscal alterations since the beginning of January 2013 will reduce GDP by 1.6 to 1.9 percentage points in 2013. Implementing further fiscal austerity at a time when the U.S. economy is fragile and unemployment rate remains high would threaten our economic recovery and increase joblessness, which, ironically, would increase the deficit even further.
The federal deficit is a problem, but it is a long-term problem. Our current political discourse would greatly benefit by addressing the deficit as such, rather than wielding fears about the deficit as a cudgel to advance partisan budgetary and legislative priorities. Moreover, the empirical data about fiscal austerity calls into question the seriousness of the Republican Party in addressing the unemployment crisis. How can the GOP be serious about creating jobs while continuing to demand severe spending cuts, when such measures increase unemployment and harm the economy?