David R. Henderson  

Reply to James Pethokoukis--and a Challenge

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Last week, James Pethokoukis of the American Enterprise Institute, an Institute with which I was affiliated in the late 1990s and early 2000s, wrote a piece titled "The dodgy austerity economics of the tea party." Here's a key paragraph:

Now there is evidence smaller government is good for growth over the longer run. But flash austerity would be quite an economic--and political--gamble to take when the economy is only growing at 2%ish, inflation is moribund, and unemployment remains highly elevated. And while TPRs [his acronym for "Tea Party Republicans"] think they have economic history on their side, that's unclear.

Then he goes through the various pieces of evidence that advocates of cuts in government spending have presented for the idea that such cuts don't hurt an economy but actually help it. In a couple of places, he cites my work.

First:

TPRs also point to US economic performance at the end of World War II. From 1944 to 1948, spending as a share of GDP plunged to 9% in 1948 from 44% in 1944. Devout Keynesian Paul Samuelson predicted such shock austerity would cause "the greatest period of unemployment and industrial dislocation which any economy has ever faced." It didn't happen. While unemployment did rise from artificial wartime lows, George Mason University economist David Henderson points out that during the years from 1945 to 1948, it reached its peak at only 3.9% in 1946, and, for the months from September 1945 to December 1948, the average unemployment rate was only 3.5%. The private-sector gained as government retreated. While total output fell by 12% in 1946, private-sector GDP rose by nearly 30%.

Pethokoukis got my affiliation wrong--I'm a research fellow with the Hoover Institution and an economics professor at the Naval Postgraduate School in Monterey--but given my high respect for the economics faculty at GMU, I'll take that as a compliment. More to the point, he correctly states my argument. But then, in an apparent attempt to refute my case with World War II, he quotes Richard Rumelt:
When hostilities ended in 1945, many expected that an expanded civilian work force, plus reduced federal deficits, would bring back the depression of the 1930s. There was indeed a brief recession in 1946, but as production was rededicated to consumers and rationing was lifted, people rushed to replace rusted-out automobiles and broken-down refrigerators. The returning soldiers got jobs, moved to newly constructed housing in the suburbs, and the postwar boom was on. And it was greatly accelerated by households' renewed capacity to take on debt.

I don't know what "renewed capacity to take on debt" means. What I do know is that the standard view that Americans drew down their savings from World War II to buy consumer goods is incorrect. Had they drawn down their savings, their saving [note the singular] as a percent of income would have been negative. In fact, it was positive, meaning that American households as a whole added to their savings. That's in my Mercatus study that Pethokoukis cites above.

Second, Pethokoukis deals briefly with the 1990s economic boom that occurred while federal spending as a percent of GDP was falling substantially. He writes:

TPRs also cite the 1990s economic boom. After the Cold War ended, overall federal spending fell to 18% of GDP in 2000 from 22% in 1991. Real US GDP, however, grew by 40% with an average annual growth rate of 3.8%. Case closed? Keep in mind that a) the spending reduction was only as a share of GDP--it rose in both inflation and non-inflation adjusted terms, b) took place over the course of a decade, and c) happened at the same time as a private-sector productivity boom. Of course, Henderson speculates that perhaps the decline in defense spending freed up knowledge workers to help make technological miracles happen in the private economy.

He's right that I speculated. It would be hard to establish that for sure. I'm not sure why the "Of course," unless it means that as someone who thinks that government wastes resources because it spends other people's money, I think that those resources are best used by people when they spend their own money. If that's what he means by "Of course," then it's appropriate.

Here's my challenge to Pethokoukis. I left it on his site as a commenter and have not heard back:

One thing I notice is that while you have criticisms of each of the cases others and I give where spending was cut a lot and the economy didn't tank, you don't actually give examples where spending was cut a lot and the economy did tank. I've been looking for those and can't find any. Do you have any?

James?


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CATEGORIES: Fiscal Policy



COMMENTS (14 to date)
8 writes:

The best argument today is the Fed's Z1 report. There is very little credit growth outside of the federal deficit. Federal debt growth from 2008 until the latest Z1 accounts for about 150 percent of credit growth in the U.S. economy. They are the borrower of last resort, the only thing staving off a massive deflationary wave.

David R. Henderson writes:

@8,
Are you accepting my challenge? I asked James for an instance where there was a substantial cut in government spending and the economy tanked. I don't think you gave me one.

Matthew Rognlie writes:
What I do know is that the standard view that Americans drew down their savings from World War II to buy consumer goods is incorrect. Had they drawn down their savings, their saving [note the singular] as a percent of income would have been negative. In fact, it was positive, meaning that American households as a whole added to their savings.
This isn't really the right interpretation - and this is exactly where the classic Keynesian "paradox of thrift" becomes relevant. The high level of savings from World War II can still have played a large role in driving consumer spending without Americans "drawing down" their savings in the aggregate.

Suppose that households hold more in savings than they desire. The only way that they can address this is by spending more (or working less, though I suspect that margin is much less active in the short run). But ignoring leakages through foreign trade, which were not quantitatively a big deal at the time (foreign trade was dominated by the aftereffects of WWII anyway), every person's spending is another person's income. Thus in the aggregate, an increase in spending prompted by a desire to draw down individual savings will not result in a decline in savings at all.

Of course, in equilibrium we expect the desire to save less translate somehow into lower aggregate saving. But the crucial mechanism that governs this process is the real interest rate, and when the real interest rate is determined in the short run by other factors (monetary policy, etc.), the standard equilibrium mechanisms will not follow. Indeed, they'll usually go in the wrong direction - the shift toward spending will create a temporary boom and encourage capital investment, thus increasing realized savings.

Think about the analogy with money. The classical explanation of how an increase in the money supply can push aggregate demand upward is that everyone tries to rid himself of his higher-than-desired money holdings. In the aggregate, of course, this is impossible (holding money supply constant), so what happens is that aggregate demand is pushed up until the ratio of output to money is consistent with money demand. There's no "drawing down" of money involved.

Frank McCormick writes:

Typo?

"I'm not sure why the "Of course," unless it means that as someone who thinks that government wastes resources because it spends other people's money, I think that those resources are best used

people when they? [when people]

spend their own money. If that's what he means by "Of course," then it's appropriate."

David R. Henderson writes:

@Frank McCormick,
Typo fixed with the insertion of a "by." Thanks.

Bob Knaus writes:

There are lots of micro examples. Take any small town next to an Army base that gets closed. There are a fair number of developing country examples. Take several East Asian countries in the late 90's, or Russia for that matter. The difference of course is that we consider government spending cutbacks in these instances to be externally imposed, not a matter of policy choice.

If you are looking for examples of large countries who voluntarily chose significant government spending cutbacks in the modern era when government spending was a major portion of the economy... you will find your data set is too small. Sure, it might happen. But it hasn't yet.

8 writes:

David,

I'm not sure there is an example that exists. When ever was the government this large, with nearly all sectors of the economy leveraged to the hilt? The marginal return on debt is negative, so I fully support ending deficit spending, which means spending cuts, but it also means that without credit, idle resources will first have to become unencumbered from their debt, and the fastest course is a deflation.

MG writes:

I think the challenge will be hard enbough for James to meet even if the Professor was more than generous in his challenge. Pethokoukis' piece is as much criticsm of TPR advocacy for fiscal discipline in the context of current discussion, as it is about economic history writ large.

In this case, his challenge could have been to find an example where spending was cut just a bit (who can say that current spending has been cut "a lot") WHILE in the context of fairly accommodative monetary policy (in deference to Scott Sumner, I say only fairly, not highly accommodative) and this caused the economy to tank.

Vangel writes:

[Comment removed for ad hominem remarks. Email the webmaster@econlib.org to request restoring your comment privileges. A valid email address is required to post comments on EconLog and EconTalk.--Econlib Ed.]

lxdr1f7 writes:

David R. Henderson

Do you agree that because the credit channel is stagnant that we need fiscal deficits? The banks aren't expanding lending to the private sector but are doing so to the treasury so if deficits didn't occur the broad money supply would be stagnant or contracting which would be adverse for gdp and UE.

Ohio Anarcho-capitalist writes:

@ lxdr1f7 -

You assume no distortions in rates caused by government in the 1st place. As long as the Fed controls the money supply, the real (free market based) rate of interest is unknowable, and distortions in borrowing will prevail.

That said, the Fed currently offers banks a superior risk-adjusted, tax free rate of return, in the context of a manipulated interest rate market, than potential market borrowers do.

Your last assumption gets the cart before the horse - in a fiat currency system that is properly managed by the monopoly issuer of money (an impossibility, but a different conversation) productivity growth should "pull" expansions in the monetary base. Expanding the money supply to "push" production creates malinvestments in the short term (booms), followed by busts in the medium term and potentially inflation in the long term.

Jon Murphy writes:

I suspect Pajser is right. I did a research paper back in my college days on Poland before and after the fall of the USSR. We do see that the cut in spending triggers a recession throughout the bloc.

But there are two questions that come to mind:

1) Was the recessions due to the large share the government had in the economy (In the USSR, government spending as percentage of the economy was approximately 57%)?

2) Was it the government cuts that caused the recession, or the complete collapse of the economic system?

I am looking to answer these two questions as I expand this paper. The current due date for it to be completed is "Whenever-I-Feel-Like-It."

John Thacker writes:

David,

I suspect that Jim's answer is that fiscal austerity doesn't cause recession when the monetary authority like the Fed moves to counter it with monetary expansion. Thus, in his view, the Fed adjusted QE to counteract the sequestration of funds and the tax increases. Fair enough, that's a reasonable view.

But that means that, assuming a competent Fed, there's nothing anti-growth about fiscal austerity in practice, according to his theory either. Perhaps combined fiscal and monetary austerity would be bad, but that's a different thing.

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