Politics & Policy

Cut to Grow

From the Aug. 2, 2010, issue of NR.

The word “austerity” has achieved ubiquity in 2010 almost as rapidly as “stimulus” did in 2009 and “bailout” in 2008. All three were ushered in by “subprime,” 2007’s economic buzzword. “Austerity” implies pain, but all it means is balancing the budget, and most economists would agree that this need not be painful. Their disagreement concerns the conditions under which a nation can balance its budget without causing pain.

The Keynesians, who advocate deficit spending for economic stimulus, are lined up on one side of this debate, arguing that the key to avoiding pain is simply getting the timing right: They say a nation should take steps to balance its budget only once it has emerged from recession. On the other side, the Hayekian advocates of limited government argue that the key is getting the policy right, regardless of the timing: Austerity through spending cuts is always compatible with growth; austerity through tax hikes isn’t.

This is an old disagreement, dating back to when John Maynard Keynes and F. A. Hayek themselves debated the question, and it will keep going long after this latest round. But new evidence has emerged, in the form of a study of recent fiscal consolidations, to support the Hayekian view.

Keynesians start from the position that recessions happen because aggregate demand falls below output, causing inventories to accumulate and businesses to cut back. They argue that deficit spending is needed to pick up the resulting slack in the economy. For this view to make economic sense, Keynesians must assume that the government is borrowing idle cash. If a bank has $1,000, it can hold it in reserve, it can loan it to the private sector, or it can loan it to the government. Holding cash in reserve is the least attractive option for a bank, because cash generates no profit. Keynesians argue that in recessions, when private-sector lending is riskier than usual, the government should discourage cash-hoarding by supplying banks with low-risk government securities in which to invest. The government can then spend the money (or cut taxes, though you’ll rarely hear a Keynesian make that argument), thus aiding the economy by creating demand.

This is a nice, tidy theory — with almost no application to the recession we’re in. The financial crisis of 2008 was not a typical business-cycle recession. It was a spectacular blowup of the financial system, involving the sudden devaluation of trillions of dollars of assets as home prices collapsed. To return to the example in the previous paragraph, the problem was not that the bank refused to lend its $1,000 to the private sector; it was that the bank suddenly lost half its money. Banks struggled to fund their liabilities, and taking on new risk was, for a time, out of the question.

This contraction of credit could be counteracted only by some combination of liquidating major financial institutions and injecting new capital into the financial system; for a variety of reasons, government officials leaned toward the latter, less efficient means, and managed to bungle even that. They protected bank bondholders from sharing in the losses when they should have made bailouts conditional on bondholders’ converting some of their debt to equity, in order to recapitalize the banks. Then they made executive pay a political football, thereby encouraging bank executives, who were eager to escape public scrutiny of their compensation, to repay bailout money as soon as their institutions could survive without it — but before they had enough capital to resume normal lending.

Meanwhile, in the broader economy, consumer demand remained relatively robust, especially considering that falling home prices meant consumers could no longer use their houses as ATMs. But policymakers botched this side of the equation, too. The Democrats launched a multi-pronged “foreclosure mitigation” project, which ended up dragging out a natural revaluation in the housing market that should have taken place quickly after the bubble popped. People who should sell aren’t selling, and people who should buy are waiting on the sidelines for prices to come down further. Bad debts linger. The question of what housing is worth — and how big the losses from the bubble’s bursting are really going to be — remains a major source of uncertainty.

It is no surprise to any student of reality that, absent policies to address the underlying weaknesses in the banking and housing sectors, stimulus measures have failed to deliver on promises of sustainable growth and job creation. On July 10, the Wall Street Journal released an analysis of unemployment trends in eleven countries, concluding: “Manageable debt burdens and healthy banking systems — areas in which the U.S. doesn’t excel — are proving to be crucial factors in creating jobs.” Whether a country responded to the recession with some form of traditional Keynesian stimulus does not appear to have played any role at all.

Democrats and other proponents of Keynesian economics warn that enacting austerity measures now would make deficits worse, because austerity would curtail growth and, subsequently, government revenues. Some go so far as to argue that government spending pays for itself through certain “multiplier” effects: Keynesian models assume that each deficit dollar spent on widgets is subsequently deployed by the widget maker on some other productive activity, thus increasing total output by more than one dollar. In conditions of high unemployment and low growth, they say, this can add up to a substantial bit of additional tax revenue.

Stilts would be embarrassed to be associated with this nonsense. It is akin to the hyperbolic line, taken up by some overenthusiastic supply-siders, that tax cuts pay for themselves. But while both arguments are exaggerated, there is an important difference: Tax cuts may not generate enough growth to be fully self-financing, but tax increases certainly create a drag on growth and reduce government revenues. Spending cuts, on the other hand, are highly unlikely to slow economic growth. That’s because multiplier effects of spending are just as real when it is the private sector that spends (or invests) that first dollar, and Keynesian theory is at its weakest when it argues that the private sector wouldn’t have spent or invested the dollar if the government hadn’t borrowed or taxed it.

As mentioned above, this debate has been going on a long time. Perhaps its best expression took the form of dueling letters to the Times of London, one authored by a group of economists including John Maynard Keynes, the other by a group including F. A. Hayek.

The letters, long forgotten but recently rediscovered by economist Richard Ebeling, were written in 1932 and concerned the “paradox of thrift,” the idea that saving can be harmful to the economy. The group led by Keynes argued, “If a person with an income of £1,000, the whole of which he would normally spend, decides instead to save £500 of it . . . there [isn’t] any assurance that [the savings] will find their way into investment in new capital construction by public or private concerns.” Keynes et al. added that “when a man economizes in consumption and lets the fruit of his economy pile up in bank balances or even in the purchase of existing securities, the released real resources do not find a new home waiting for them.”

The group led by Hayek agreed that “hoarding money, whether in cash or in idle balances, is deflationary in its effects,” and thus not desirable; but they rightly rejected the idea that investing in securities, and thereby providing productive enterprises with capital, contributed nothing to the economy.

Further, an investor or institution that is truly hoarding cash is not likely to be suddenly persuaded to loan funds to the government simply because Congress decides to pass yet another stimulus package. If such a person were inclined to buy government securities, he would find that there already exists an abundance of them from which to choose. Cash-hoarding is rare. It is more likely that the risk-averse investor or institution will go with cash equivalents: short-term loans to governments and corporations that pay a relatively low rate of interest.

The point is that far from being “idle money,” these savings are invested. Hayek’s group argued that this activity is essential, especially in an economic downturn: “We, [contrary to Keynes et al.], believe that one of the main difficulties of the world today is a deficiency of investment. . . . Hence we regard a revival of investment as peculiarly desirable.” Nor did the signatories of the Hayek letter support fiscal stimulus to counteract the workings of the market: “At best,” they wrote, these measures “mortgage the Budgets of the future, and they tend to drive up the rate of interest.”

Keynesians are quick to point out that, so far, we haven’t seen the kind of interest-rate pressure that Hayek mentioned in his letter. The reason is obvious enough: With a Democratic Congress swinging its wrecking ball through the private economy, and with other developed countries in even worse fiscal messes than ours, Treasury notes look like a safe investment relative to corporate bonds and other forms of debt. But low rates on Treasury notes should not be taken as a vote of confidence in the U.S. government’s fiscal stewardship. Other indicators, such as the soaring price of gold, reveal a profound uneasiness with Treasuries, too. The Keynesians are wrong: The time to get our fiscal house in order is now.

The way we get it in order — the policy mix we use to rectify our structural deficit — is the thing that matters, and a body of research, including a recent paper from Harvard economics professors Alberto Alesina and Silvia Ardagna, indicates that there is a correct way to balance the budget. After studying more than 100 instances of fiscal consolidation, Alesina and Ardagna concluded that “spending cuts are much more effective than tax increases in stabilizing the debt and avoiding economic downturns,” and identified “several episodes in which spending cuts adopted to reduce deficits have been associated with economic expansions rather than recessions.”

We’ve tried the Keynesian approach, and it hasn’t worked. The question we have to ask ourselves is whether we want the economic buzzword for 2011 to be “recovery,” or “broke.”

Stephen Spruiell is an NRO staff reporter. This article first appeared in the Aug. 2, 2010, issue of National Review.


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