Proponents of higher government spending have used the Great Recession to argue that balanced government budgets hurt economic growth.
In a new paper published by the National Bureau of Economic Research, economists Antonio Fatás and Larry Summers argue that deficit cuts during the recovery from the Great Recession, particularly in Europe, seriously hurt growth prospects in the long run.
Their approach, however, assumes away the key policy question—whether deficits can be shrunk without inviting a recession—instead of tackling it directly.
An ample empirical literature has shown that although tax increases and spending cuts can both decrease deficits, they have markedly different effects on economic growth: Tax increases are much worse for growth.
In their paper, Fatás and Summers lump tax increases together with spending cuts, and then compare the effect to growth forecast errors, which reflect the degree to which pre-crisis economic models were inaccurate.
They conclude that deficit cutting is more harmful to economic growth than the models implied. But a quick glance at the data suggests that forecast errors in 2011-2012 were strongly predicted by tax increases, but not by spending cuts.
By lumping the two strategies together, Fatás and Summers mislead policymakers.
Fatás and Summers also portray austerity as a choice made by eager politicians. However, despite lots of hectoring by economists, few governments made major cuts before bond markets forced them to act.
Examining a similar set of countries, I found that 12 reduced government spending from 2007 to 2012. Of those, 11 faced significant pressure from bond markets, substantially limiting their ability to run deficits unabated.
However, the choice of policy mix differed widely across countries. Although the majority emphasized spending cuts, a minority led with tax increases.
For policymakers in a crisis country such as Ireland or Portugal, the question is not so much whether to cut the deficit, but how. A large and compelling body of evidence says that spending cuts do much less damage to future growth than tax increases do.
