We admit correlation doesn’t imply causation, but we’ll use fancy words to trick you anyway

James Pethokoukis asks whether spending austerity is the path to prosperity in the US:

So this is my take: Spending cuts can be pro-growth, certainly over the longer term, all else equal. But neither party in Washington has offered a financially and politically realistic path to lower spending — certainly not low enough to balance the budget in a decade — that wouldn’t also, say, risk US defense and basic research capabilities.

Here’s the evidence he starts with:

Researchers tend to find a negative relationship between the size of government and economic growth in advanced economies. After surveying the literature […] it’s “fair to say than an increase in total government size of ten percentage points in tax revenue or expenditure as a share of GDP is […] associated with an annual lower growth rate of between one-half and one percentage point.”

For one, this ignores the fact that many of us who believe in fiscal stimulus today don’t necessarily have stronger priors about government spending, just that at a zero lower bound deficits can be self-financing. But more importantly, the whole, carefully placed, correlation can be rejected with the syllogism:

  1. Researchers tend to find that richer economies have bigger governments (because, you know, they do)
  2. Researchers tend to find that richer economies have slower growth rates (notice that “developed” isn’t a progressive verb)
  3. Therefore, bigger governments must be associated with slower growth rates.

You see, this whole argument is tautological: growth can’t be sustained forever. If the simplistic argument I presented is correct, and growth rates are the ultimate goal, we should move towards becoming India, or something. My argument is, of course, shoddy and, by extension, the idea that government spending is anemic to growth (especially in depressed conditions) is, as well. 

Pethokoukis further develops his argument with a blatantly incorrect op-ed from a former Romney advisor:

First, the lower level of future government spending avoids the necessity of sharply raising taxes. The expectation that tax rates won’t need to rise provides incentives for higher investment and employment today. Second, since the expectation of lower future taxes has the effect of raising people’s estimation of future disposable income, consumption increases today. Third, the new budget’s reduction in the growth of government spending is gradual. That allows private businesses to adjust efficiently without disruptions.

Noah Smith and Paul Krugman have already wrecked this argument, and I can’t do any better. 


Upshot: If you have no Zero Lower Bound, and if the Fed partially counteracts the demand-side effects of fiscal policy, and if people have forward-looking expectations, and if you don’t cut government purchases much, and if taxes are very distortionary, then austerity works. This is not really a new result, but it rarely gets shown so explicitly, so it’s good that John Taylor and his co-authors went ahead and did it.
That said, the result basically ignores the real Keynesian critique that has emerged since 2008, which is that the Zero Lower Bound matters a lot. It also probably assumes that taxes are a bit more distortionary than they really are. And it also probably overestimates the Republicans’ real willingness to cut transfers (entitlements are the “third rail”, after all), and underestimates their willingness to cut government purchases. In real life, spending cuts usually fall on the things that are politically most easy to cut, but are economically most valuable in both the short and long runs – infrastructure and research. Finally, Taylor’s plan ignores distributional concerns, but that’s pretty much par for the course.

Let’s think this through. If you take $200 billion a year from the poor and hand it to the rich, and people believe that this transfer is forever, permanent income theory says that consumption among the poor should fall by $200 billion while consumption among the rich rises by the same amount. There are, however, two reasons not to believe this.

One is that there is some evidence that permanent income doesn’t work all that well, that the rich persistently consume less of their income than the poor.

More to the point here, however, is that it’s very likely that people would view both savage spending cuts and the tax cuts they pay for as less than permanent, likely to provoke a backlash or at any rate a reversal at some point. And in that case the rich would not spend all of their tax cut.

Economists don’t talk about the moral importance of spending in a recession. Unemployment insurance and transfers are discussed in the scope of Keynesian stimulus, and basically all the debate is framed around this attractor. But in a recession, the poorest and most vulnerable loose their jobs. And, when growth resumes, most of the income returns to a vanishingly small percent of the population.

Basically, a financial recession is a redistribution of wealth, to the rich. Not only is the argument against economic stimulus wrong logically, it’s wrong morally. I believe in hard work and fair taxation as much as the next guy, if you don’t believe me, read about my admiration for American conservatism. (Also read Brad DeLong’s takedown of bad conservative ideas with good conservative ideas, notably Milton Friedman).

Unemployment insurance makes sure insures that unemployed parents can continue to buy books for their kids and put food on the table. Transfers help the poor recover from predatory practices (and, admittedly, their own stupidity for buying things they can’t afford – but not their kids’, who will ultimately pay for society’s apathy).

Maybe tax cuts pay for themselves. The argument Pethokoukis presents is unconvincing but, even if they do, the deficits we incur today to build our way out of this recession won’t matter. When the Republicans claim that we should offset any tax increases with spending cuts, I really scratch my head. Because, right now, they both suck for the economy. 


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