In this piece, The Economist stays loyal to its position that government spending can boost the recovery and goes after the idea that austerity measures are good for the countries that adopt them. In particular, it questions a paper by Harvard economists Roberto Alesina and Silvia Ardagna called “Large Changes in Fiscal Policy: Tax vs. Spending,” in which Alesina and Ardagna show that tax cuts are more likely to increase growth than spending increases and that spending cuts without tax increases are more likely to reduce deficits and debt-to-GDP ratios than tax increases. Also, they note that adjustments on the spending side are less likely to create recessions than those on the tax side.
In a recent paper for the Mercatus Center, Alesina argues that not only are austerity measures likely to be better for the countries adopting them than tax increases, but also that the politicians adopting these measures will be rewarded at the polls:
First of all, not all fiscal adjustments cause recessions. Countries that have made spending adjustments to reduce their deficits have made large, credible, and decisive cuts. Even in the very short run,many reductions of budget deficits, even sharp ones, have been followed immediately by sustained growth rather than recessions. Second—and this is most likely a consequence of the first point—it is far from automatic that governments that have reduced deficits have routinely lost office. Governments that have initiated thorough and successful fiscal adjustment policies have not systematically suffered at the polls, especially when the electorate has perceived the urgency of a crisis or the possibility of defaulting on an external commitment. For instance, when several European countries had to tighten their fiscal belts to enter the European monetary union, many governments that successfully implemented fiscal adjustments were reelected.Thus, according to recent evidence, there could be reasons to be less pessimistic.
The Economist says that a recent IMF paper, “Will It Hurt? Macroeconomic Effects of Fiscal Consolidation” (chapter 3 of the IMF’s October 2010 “World Economic Outlook”), calls it wishful thinking to imagine that austerity measures won’t result in a recession.
Now, Alesina has responded to the Economist.
The Economist tries to portray our paper and the WEO Chapter as polar opposites. In reality they agree on many points. In particular, they find the same critical result, and potentially the most important one: tax increases are much worse for the economy than spending cuts.
The WEO Chapter argues that this effect comes mainly from different reactions of monetary policy, but their claim of having identified separately all of these channels is overstated because interest rates, current and expected, and exchange rates are endogenous to both fiscal and monetary policy. In addition, our paper and the WEO Chapter also agree that after a few years, even large (but spending based) fiscal adjustments create growth for the economy. Our paper and the WEO Chapter achieve the same results using very different methodologies. We use simple statistics and econometric analysis, they use a complex dynamic general equilibrium model. Our time framework of comparison before and after the fiscal consolidation is a five-year window (from two years after, to two years before the adjustment). This is exactly the same window around which the WEO Chapter finds that a reduction of the debt has positive effects on growth, as long as taxes are not raised.
The main difference between Alesina and the IMF paper is how they define fiscal adjustments. Unlike the IMF, Alesina’s original paper raises the potential issues with his methodology and spends some time explaining why, in spite of some limitations, this methodology is worth using. In his response, he shows that the IMF’s methodology also has pros and cons.
Now, after reading the IMF report, The Economist piece, and Alesina’s response, I am left wondering whether The Economist is not the one guilty of wishful thinking. But who would wish for more government to be the solution to this crisis?