Arnold Kling  

Austerity Within Reason

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This month's issue of Reason has an article about fiscal tightening moves that did not cause macroeconomic disaster. I discuss the demobilization after World War II. Maurice McTigue discusses New Zealand 25 years ago. David Henderson talks about Canada 15 years ago.

Can one argue that these examples are not relevant today in the U.S.? Certainly. I present some of the arguments in my article. Still, I would say that the biggest iron law of fiscal policy is that We Don't Know. Some economists have models that tell us what the effects will be, assuming that the models are right. But we don't know whether or not the models are right.

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COMMENTS (7 to date)
Sean S. writes:

"All models are wrong, some are useful.""
Then you have models they use in finance!

Keith writes:

Why is this a mystery?

Government's spend our money, acquired via taxes or borrowing. If governments stop spending our money, then we spend it.

Economic growth is driven by investment, not government spending. When government spending declines (especially that financed by borrowing), more of a nation's income is available for investment. With more investment, economic growth accelerates.

Most modern government spending is consumption oriented, not investment oriented (this is especially true of wars). Reduce government spending and a nation's effective savings rate will generally rise (the amount of income actually invested) and economic growth will hence generally rise.

Perhaps economic models should focus on the actual mechanisms that generate income (capital and labor and the successful exchange of their production) and track actual flow/exchange of income. It might be insightful. For a look at a very simple model that attempts to do just that, take a look at the below link (it is a Solow type capital accumulation model that tracks the flow of gov borrowing):

Salem writes:

One might also usefully add the UK's austerity budget in 1981. It was denounced by the Keynesian orthodoxy at the time for raising taxes and cutting spending in the middle of a recession. Yet it was highly successful, and many of the signatories of the famous letter have now recanted - including the current Governor of the Bank of England.

Ted writes:

Here is my view on contractionary fiscal policy:

i) Large fiscal contractions can be expansionary through the permanent income channel. If a fiscal contraction is large enough such that the expectations of consumers future tax liability is significantly reduced, this will cause them to increase their permanent income estimates and lead to greater current and future consumption. Of course, this also means that you don't actually have to do fiscal contraction now you can pass a bill that says fiscal contraction will begin later. But it's possible that unless "the pain" comes right now the public may not believe the future cuts will come in and their expectations will not be altered (i.e. time inconsistency).

ii) Smaller contractions will likely be neutral or contractionary. Gimmick crap like 5-year spending freezes will likely just contract activity since it doesn't cause any significant revision in estimates of permanent income. However, most of the time when the government contracts spending, monetary policy would react by being expansionary and largely offset this problem. The problem is rates are stuck at zero right now and our Federal Reserve has decided not to manipulate expectations. So, small contractions are either neutral or slightly contractioanry, depending on the stance of monetary policy.

So, fiscal contractions can be positive if they are large and significant and cause a reduction in expectations of future tax liabilities. Or they can be largely netural if monetary policy is able to offset them if they are the small kind.

Otherwise they are bad, and right now we are in the bad part. Congress doesn't have the political will to massively restructure these programs right now and the Fed is incompotent.

Æternitatis writes:

Good article, but where did you get this from?

Back then, federal spending was much larger as a share of GDP (40 percent, vs. less than 10 percent today)
Every figure for current federal spending I've seen in many a year has been in the 20-25% of GDP range.

stubydoo writes:

Is the experience of New Zealand from 25 years ago relevant? Yes.

Does it support the conclusions endorsed by Messrs McTigue and co.? Absolutely not.

McTigue is blatantly messing up the chronology of events (OK, it's only blatant to those with knowledge of New Zealand events. Shame on Mr. McTigue for counting on the ignorance of his audience).

The unemployment peak of 11% mentioned in the article occurred in 1992, seven years into the reform package as dated (more or less accurately) in the post here as 25 years ago.

The actual facts of the New Zealand experience indicate that a policy package along those lines will lead to a solid half-decade or so of unprecedentedly high unemployment (followed ......eventually...... by the intended good outcomes, assuming the voters don't get mad enough in the meantime to vote in someone who will undo it).

(yes, for those in the know, there was a big confounding shift in monetary policy as well, but if McTigue is allowed to ignore it then so am I).

Matt Nolan writes:

The description of NZ is so amazingly false ... and coming from someone who was in parliament at the time I'm shocked.

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