Tuesday, June 15, 2010

Austerity stimulus?

For more than a year, conservatives have made clear their opposition to so-called stimulus spending. Citing high deficits and ineffectiveness, the right has embraced austerity measures to reduce the government’s gusher of red ink.

Whatever the relative merits of stimulus vs. austerity, until recently the conservative argument focused on concerns that fiscal deficits would lead to increased interest rates, or a dollar devaluation, or higher taxes. Reasonable arguments all.

Now, a novel and more far-fetched argument has emerged – that spending cuts are not only benign, they stimulate economic growth.

The first such analysis came from Professors Jason E. Taylor and Richard K. Vedder, courtesy of the libertarian Cato Institute. Their article points out that after World War II, the U.S. government downsized radically, leading the era’s Keynesians to predict a contraction. Instead, the argument goes, the economy boomed indicating spending cuts are stimulative.

What is missed is that the pre-war Great Depression economy was hampered by three policy missteps, uniquely compounded.

First, as John Tamny recently suggested, the 1920s were likely deflationary. While gold was fixed by law at $20.67, a wide array of other commodity prices dropped significantly during this era, indicating dollar scarcity. Due to the unstable world currency system, in the late 1920s and ‘30s European nations initiated a round of competitive devaluations, leading to monetary chaos.

Second, as Congress moved to enact the 1930 Smoot-Hawley tariff, markets anticipated its damage, leading the Dow to plunge in 1929.

Third, in 1932, the U.S. raised the top tax rate from 25 percent to 63 percent.

The U.S. moved out of depression in the early 1940s for several reasons. As wartime mobilization took hold, the U.S. reduced tariff barriers among allies. Then, in 1944, the U.S. and key nations reached agreement on the Bretton-Woods currency system, with the dollar pegged to gold at $35 and the other currencies fixed to the dollar. After the war, the currency system was extended to the rest of the developed world, while the U.S. cut tax rates at home.

Add to this, tremendous pent up demand at home and abroad, especially in decimated Japan and Germany, which responded to their ruination by cutting taxes deeply, leading to dynamic expansions, some of which went to buying U.S. goods.

Lower tariffs, lower taxes, a global sound money system, and of course, peace. No wonder America boomed after the war.

A second version of the spending-cuts-as-stimulus argument appeared last week courtesy of Steve Hanke, also of Cato. While Hanke is often excellent on monetary issues, apparently he is no supply-sider when it comes to fiscal analysis.

Hanke cites several examples of spending cuts coinciding with economic expansions.

One is Margaret Thatcher’s spending cuts in 1981. Nowhere mentioned is that era's plummeting British inflation rate – made possible, in part, by the dollar’s parallel rise – and Thatcher’s significant tax rate reductions, both profoundly bullish.

Hanke also mentions Ireland’s spending cuts of 1987-89. Again, no mention of the period's significant tax rate cuts.

And, Hanke sites the Danish spending cuts of 1983-86. While tax cuts were not part of Denmark’s growth spurt, its decision to fix its high inflation currency to Germany’s low-inflation deutschmark in these years surely was.

None of this is to endorse stimulus spending; to the contrary. But in high unemployment periods, the best answer to demand-side spending stimulus is not fiscal austerity. It is the pain-free, pro-growth policy mix of tax rate cuts and a sound dollar.


  1. Sean,
    Given how simply out-of-control government spending is on the federal, state, and local levels, couldn't a reasonable case be made that spending cuts would be stimulative? Here's my simple reasoning (with a HT to John Tamny): Limited capital that had been sucked up by the public sector is now made available to the private, productive sector. The private sector can then use that capital to expand by making investments in both labor and productivity-enhancing capital equipment. Of course, in combination with sound money and pro-growth tax policy, this would be a huge boon to the economy. As Tamny has emphasized in the past, government spending is just another form of taxation. Reduce the burden of taxation (spending) and you increase the incentive to invest/work.

  2. Bob--
    Tamny is no doubt correct, but I don't see high federal spending as the reason investors are sidelined and unemployment is high. Stabilize the dollar and keep taxes low, and plenty of capital will become available for private purposes.
    Without those supply-side fixes, deep spending cuts -- especially in the social welfare arena -- while technically correct, likely will cause civil unrest and derail larger reforms. As a result, voters will hedge by not giving spending cutters an outright majority, leading to the type of incoherent muddle we now see in Britain.
    Better to restore growth and prosperity first, then focus on spending cuts when the public is more economically secure.