Austerity Really Is Austere: The Argument That We Can Shrink Our Way to Prosperity Was Always Weak, and It Gets Weaker Every Day

Posted in: Tax and Economics

Economists generally refer to government budget cuts and tax increases as “contractionary policies,” because both types of policies are expected to cause the economy to shrink.  When the economy is already quite weak and threatening to fall back into recession, as it has been for the past several years, we should thus generally want to adopt “expansionary policies,” that is, spending increases and tax cuts—or, more specifically, tax cuts aimed at the non-wealthy, who are almost certain to spend the money they save due to the tax cuts when the economy is weak.

That was the thinking behind the 2009–10 stimulus program, a combination of tax cuts and spending increases that the new Republican majority in the House of Representatives has refused to renew in any form.  Indeed, the policy agenda in Washington for the past year has been to contract, contract, and contract some more.  Just this week, the House refused even to extend the temporary payroll tax cut, or to approve spending to extend benefits for the jobless.

Is there any sense at all behind this counterintuitive approach to budget policy, as a matter of economics?  To be sure, there is good reason to suspect that the central motive for Republicans here is not based on economics at all, but rather on the pursuit of partisan advantage.  If, as most analysts believe, the party that holds the White House generally is saddled with the blame for a weak economy, then the Republicans stand to gain from the continued high unemployment and other ills of our struggling economy, even if those ills are needlessly exacerbated by the Republicans themselves.

While it would be the height of cynicism to pursue such a strategy—to be willing to doom millions of people to despair, want, and possibly even death, simply so that Republicans can win an election—sadly, we cannot rule out that motivation for any number of U.S. politicians.

Surely, however, there could be some American politicians who have sincere motives for advocating spending cuts and tax increases in the face of a weak economy—believing that such policies will actually help the economy to recover.  Moreover, this perverse desire to enact austerity policies in the face of near-depression conditions also exists in Europe, suggesting that there is something more than bare-knuckle Red State/Blue State politics at work.

There is, in fact, a facially plausible theoretical argument in favor of “expansionary austerity”—the policy of imposing immediate pain on a country’s people, in the belief that doing so will strengthen the economy.  And, like all theories, this argument can be tested against the available evidence.

The evidence supporting the idea that austerity can lead to prosperity was never strong, however, and all of the evidence that has accumulated during the current crisis further undermines any hope that we can simultaneously take money away from people and watch the economy grow.  Austerity truly is austere, and we should stop fooling ourselves into thinking otherwise.

The Sources of Economic Growth, and the Government’s Role in Expanding the Economy

A country’s Gross Domestic Product (GDP) represents the total of all incomes earned in an economy in a given year.  Those incomes are earned by selling goods and services to four broad groups of spenders: (1) domestic consumers (usually referred to simply as “consumption”), (2) domestic businesses (“investment”), (3) governments at all levels (“government spending”), and (4) foreign customers (“net exports”).  If any one of those four components falls, then the economy will shrink, unless one or more of the other components of spending rises to make up the difference.

When the economy is weak, policymakers generally look for ways to increase GDP, as a way to increase people’s incomes (in large part by reducing unemployment).  The most direct way to do so, it would seem, is to have the government sector increase its own spending.  Because of the virtuous cycle known as the “multiplier effect,” such government spending can also lead to increases in consumption:  As the initial government spending puts people back to work, they then spend their money in ways that leads to still more hiring.  Once the economy begins to expand, the business sector then has renewed reason to expand its operations and hiring, in order to be able to meet the demands of its newly enriched potential customers.

This logic generally does not work when the economy is already strong, however, because there are effectively no workers available to expand the economy’s output.  Thus, in a booming economy, policies that are thought of as expansionary do little more than move economic activity among the four components of GDP described above.  (Expansionary policies can also, under such conditions, lead to increases in inflation.)

Therefore, even the most standard economic analysis tells us that not all seemingly expansionary policies will actually be expansionary.  Spending increases and tax cuts can lead to greater prosperity, but only if the economy is not currently operating at capacity.

The Clever Logic of Expansionary Austerity: Can the Other Parts of the Economy Pick Up the Slack?

Can an automobile speed up, even after the driver has slammed on the brakes?  It certainly can, if the driver is also pressing the accelerator to the floor—or if the car is on an icy slope, or under various other imaginable scenarios.  Can a house become colder, even after the heat has been turned up?  Again, yes.  If one opens the windows and doors, or if the outside becomes still colder, then it is possible to attempt to move the temperature on the thermostat in one direction, only to see the temperature inside the house move in the other direction.

The logic of expansionary austerity relies on similar logic.  Under this theory, a cut in government spending, or an increase in taxes on the non-wealthy, will be offset by other, predictable changes in the economy, making what might appear to be a contractionary policy actually expansionary.

In particular, the idea is that businesses will view a cut in government spending not as a reason for further retrenchment—which would be based on the concern that an austerity program will make it harder to find customers with money to spend—but as an opportunity to expand their businesses.

But why, one might ask, during a recession or depression, would businesses that would otherwise wish to expand their operations need to wait for the government to cut its spending?  There is already a large pool of unemployed workers from which to choose, and it also would be quite inexpensive to expand a business’s productive capacity.  What is it about the government’s decision to contract its spending that could inspire businesses to expand theirs?

The answer is that businesses might view the government’s decision to cut spending as a reason to feel more confident about the future of the economy.  If businesspeople are convinced that the government is too large, then they might cheer any news that suggests that the playing field will be left to businesses in the future.

If this increase in business confidence is going to have a net expansionary effect on the economy, however, it is important to remember that it is not sufficient that businesses simply increase their investment spending.  They must, in fact, increase their investment spending by more than enough to outweigh the contractionary effects that we would see if the government’s austerity policies were viewed in isolation.

This is why most economists have been so skeptical of the notion of expansionary austerity.  Two highly unlikely things must happen for such a policy to succeed: first, businesses must not lose confidence due to the reduced spending in the economy, and second, businesses must actually increase their spending due to the belief that the government is now “getting out of the way”—in an economy in which the only thing standing in the way of business expansion is the lack of spending itself.  And, again, that second effect must be not merely greater than zero, but greater than the government’s cutbacks.

Despite these strong reasons for doubt, however, there is at least a plausible chain of events that an austerity program could put into motion, allowing it to lead to a net positive effect on the economy.

Such a positive effect on the economy could even be enhanced, if the austerity program were to inspire domestic consumption spending, or if net exports were to rise.  Again, it is not clear how domestic consumers would increase spending, when they are already constrained by the weak economy.  Moreover, because of the vote by House Republicans this week, consumers will now see their payroll taxes going up (if they are lucky enough to be working) or their unemployment benefits disappear (if they are among the millions who have lost their jobs).  It is even more difficult to imagine how foreign buyers would view the government’s austerity program as a reason to feel greater confidence.

Even so, the expansionary austerity claim is a testable proposition.  Can we find recent experiences in the United States or other countries in which contractionary policies have led to an expanding economy?  Unfortunately, the evidence is overwhelming, and it clearly demonstrates that austerity is, in fact, contractionary.

The Evidence: Expansionary Austerity Is a Pipe Dream

Because economists do not have the benefit of controlled laboratory experiments—we cannot, for example, have “experimental” and “control” groups to determine whether a policy is expansionary or not, holding all else constant—we are left to search the historical record for examples of cases in which decreases in government spending have been followed by increases in GDP.  Even though the cause-and-effect relationships in such episodes would still be in doubt, they would at least give us some reason to suspect that austerity policies are not the death knell for an economy.

And, a search of the historical record shows that there are, in fact, instances in which one can find a government cutting spending, followed either by no contraction in the economy, or even by some increase in GDP.  (I discussed the evidence on this point earlier this year in a post on the Dorf on Law blog.)  The problem is that those examples are, upon deeper inspection, not applicable to the current situation in the United States.

Why the Only Plausible Example of Successful Expansionary Austerity Policies—Ireland in the 80’s—Is Inapplicable to the United States’ Situation Today

Most importantly of all, only one of those episodes saw a country that was currently experiencing a deep slump, as America is now, enact contractionary policies.  As noted above, expansionary policies would generally not be expected to be expansionary, while contractionary policies would be much more likely to be offset by other types of spending, in a strong economy.  All of those episodes that took place outside of recessionary conditions are, therefore, simply not a test of the theory of expansionary austerity.

Moreover, that one remaining example, Ireland in the late 1980’s, is especially unhelpful in informing current U.S. policy debates, because (among other things) Ireland’s exports rose dramatically due to factors beyond its control.

In short, Ireland got lucky.  Moreover, the luck of the Irish (which, as we know, was radically reversed during the current recession) is not of the sort that the U.S. could hope to replicate today.  Our foreign trade partners are themselves enamored of contractionary policies, with each of them imagining that they will be saved by being able to increase exports to some other country.  But exports can only increase if some other country is importing those goods.  And, in the current environment, there are no countries stepping up to buy our goods.  That means that, in both the U.S. and Europe, contractionary policies will not be offset by foreign sales.

It is also notable that the Irish example is not actually an affirmation of the mechanism that is supposed to drive expansionary austerity: increased domestic spending.  It was not the case that the Irish business sector was so excited by the austerity program that its companies increased business spending and thus sparked an expansion.  Confidence did not save the day in Ireland.  Foreigners did.

Recent Experience Does Not Offer Any Reason to Believe in Expansionary Austerity; Quite the Contrary

What about more recent experiences?  The experience with the U.S. stimulus package at the beginning of the Obama Presidency provides strong evidence against the theory of expansionary austerity.  The stimulus spending was not ideal: It was much too small, and state and local governments largely offset the expansionary impact of the federal spending increases due to the contractionary effect of their own cuts.  However, despite its flaws, the stimulus actually did make the economy much stronger than it otherwise would have been.  The Congressional Budget Office estimated that, without the stimulus bill, the unemployment rate would have been one or two percentage points higher in 2010 than it actually was.

Similarly, when the stimulus spending ended, and the contractionary policies of the last year kicked in (again, with even stronger help from the withering state and local government sector), the signs of hope in the economy disappeared, and the possibility of renewed recession became a serious concern.

The experience here has, moreover, been replicated abroad.  The new Conservative Cameron Government in the United Kingdom came into office promising an austerity-led expansion.  They delivered on the austerity, but (even though the U.K. has its own currency, freeing it from the major constraint facing many weak Euro Zone economies) the promised expansion has not come close to materializing.

Interestingly, the Irish economy is now, once again, being touted as a possible example of the wonders of expansionary austerity, as is Latvia’s.  Even leaving aside the dubious relevance to the United States of the experiences of such small economies, it is notable that “success” in those contexts looks nothing like prosperity.  Unemployment is still high, and incomes are still low.  In Ireland, foreign companies are expanding their production, but without hiring more than a handful of Irish workers.  While more goods are being produced there, the people themselves feel none of what little prosperity has followed severely contractionary policies.

Defenders of the theory of expansionary austerity are, perhaps not surprisingly, undeterred by the historical record or by recent experiences.  They will surely continue to point to isolated examples as possible validation of their preconceived notions.  For everyone else, however, what is most notable is that the evidence is so unambiguous.  This is not a matter of trying to decide whether, say, a 60-40 split in the evidence is enough to validate or invalidate a theory.  The situation, if one looks at the evidence, is much more dramatic than that:  There are simply no examples to support the idea that the United States (or Britain, or the Euro Zone), in its current circumstances, should expect to spark an economic expansion by cutting government spending.

It would be nice if we could wave a magic wand and have the economy miraculously expand without our making difficult policy choices.  The supposed confidence-inspiring powers of austerity programs, however, invariably fail to materialize.  It is time to stop wishing, and instead to accept what the evidence tells us: Austerity is austere, and expansion is expansionary.

Posted in: Tax and Economics