Stopping the Keynesian Death March

John P. Cochran * Ludwig von Mises Institute

In a previous Circle Bastiat post, I highlighted Rothbard’s recommendations for reducing deficits.

The two major points were:

1. “While deficits are often inflationary and always pernicious, curing them by raising taxes is equivalent to curing an illness by shooting the patient.”

2. “Deficits, then, should be eliminated, but only by cutting government spending.”

In “Escape From Spending Hell” (Wall Street Journal,March 14, 2013), Daniel Henninger discusses recent work on austerity programs by Harvard economist Alberto Alesina (with Carlo Favero and Francesco Giavazzi) that provides strong historical support for Rothbard’s points.

Henniger summarizes the current problem and possible policy options as follows:

Ever since Ronald Reagan legitimized the efficacy of tax cuts, Democrats have sought to discredit his idea and restore the New Deal theory of a Keynesian multiplier, which dates to 1931. It holds that more public spending will revive a struggling economy.

No president has believed more in the miracle of the multiplier than Barack Obama. Across four years he has led the country on a kind of Keynesian death march, pushing federal spending to 25% of GDP and producing weak growth. We’re looking at four more years before the Keynesian mast unless the Republicans can offer an intellectually respectable alternative.

Mr. Alesina has identified the alternative. His work the past decade with how struggling economies revive suggests that the Obama spend-more solution is the opposite of what the U.S. should be doing.

The work on which Mr. Henniger’s commentary is based is “The output effect of fiscal consolidations” (August 2012 for the National Bureau of Economic Research). Henniger argues that there is a general consensus on two things:

(1) The U.S. economy is emerging from the deepest recession (depression) since the Great Depression followed by, I would add, the most anemic recovery since the Depression.

(2) The public “debt level is unsustainable.”

What are the relevant results highlighted in the paper? From the abstract:

This paper studies whether fiscal corrections cause large output losses. We find that it matters crucially how the fiscal correction occurs. Adjustments based upon spending cuts are much less costly in terms of output losses than tax-based ones. Spending-based adjustments have been associated with mild and short-lived recessions, in many cases with no recession at all. Tax-based adjustments have been associated with prolonged and deep recessions. [Emphasis mine]

Last August, in The Kindest Cuts, Alesina summarized his research for City Journal. His conclusion, “Shrinking spending reduces deficits without harming the economy—unlike tax hikes.” Alesina characterizes the debate as between “deficit hawks” (supply-siders) and their opponents (Keynesians of all stripes). The “hawks” see the size of government (nearly 25% of GDP in the U.S.) and mounting debt as the major factor retarding economic growth. Thus, “There can be no sustained growth, say the deficit hawks, unless we start balancing our books.” The opponents see a sluggish economy held back by insufficient aggregate spending as the major current problem. For them, “we should eventually rein in deficits—but right now, when economies worldwide are weak, is the wrong time.” Their solution, “Governments should instead continue to run deficits and paper them over with borrowed money [or massive money creation], waiting to balance their budgets until economies get stronger.”

Alesina, correctly in my view, points out:

The deficit debate is often misleading, however, because it tends to ignore a huge difference between the two kinds of deficit reduction. The evidence speaks loud and clear: when governments reduce deficits by raising taxes, they are indeed likely to witness deep, prolonged recessions. But when governments attack deficits by cutting spending, the results are very different.

I would add that the deficit debate is misleading in another way as well. It diverts attention away from the actual problem; the size of government relative to the economy (see “A Free and Prosperous Commonwealth”). By focusing on the deficit as the problem, it makes it appear that there are two solutions to the problem, cut spending or raise taxes. Alesina’s research demonstrates why this second option, which appears as a possible solution only if the focus is on symptoms (deficits and debt) and not on the actual problem that inhibits innovation and growth: the relative size of the public sector (see Gwartney, Holcombe, and Lawson, “The Scope of Government and the Wealth of Nations).”

continue article as Mises.org:

http://mises.org/daily/6390/Stopping-the-Keynesian-Death-March