Austerity stimulus 2.

Last week, Business Week had the latest entry in the spending-cuts-are-stimulative debate with a profile of Harvard economist Alberto Alesina:

Alesina argues that austerity can stimulate economic growth by calming bond markets, which lowers interest rates and promotes investment. In addition, he says, deficit-cutting reassures taxpayers that more wrenching fiscal adjustments won't be needed later. That revives their animal spirits and their spending. Alesina says that as a way to shrink deficits, spending cuts are better for growth than raising taxes.

Though Business Week acknowledges the current U.S. situation is different from those studied by Alesina, the article concludes with him reasserting that the U.S. should cut spending.

While I support smaller government and don't support Keynesian spending as an economic remedy, I see the Right's current focus on cutting spending as misguided, especially under the guise that it will stimulate significant growth.

Pro-growth policy should focus on supply-side measures such stabilizing the floating dollar against gold, fixing exchange rates with the euro and yuan, extending the 2003 tax cuts, and reducing the corporate income tax. Without those measures, I don't see spending cuts doing a lot to get unemployment down and GDP surging.

Moreover, there's really very little evidence that deficits in themselves play a major role in economics, positive or negative. Deficits tend to be big when the economy is bad, and small when it's good. Correlation, not causation.

Regarding Alesina, obviously he's a demand-sider, focused raising consumption. He does not mention the unstable dollar, seems to have no problem with loose monetary policy, and appears to exclude international currency swings from his analysis. He mentions Japan's Lost Decade, but omits that it occurred not because demand was low and government spent too much or not enough. Rather, Japan fell into malaise because the U.S. forced Japan to raise the yen excessively, causing yen/gold price to fall by more than half as a brutal monetary deflation took hold. That's why the Japanese stopped spending, not because of fiscal deficits spooked consumers.

Presumably Alesina's other case studies all involve non-budgetary factors -- lower taxes and tariffs, declining inflation, falling interest rates, and rising foreign trade. (See my previous post on this, here.)

According to the supply-side canon, recession occurs because economic production is blocked by one of two factors: fiscal policy error or monetary policy error. How do spending cuts in themselves reduce high taxes or stabilize fluctuating currency?

Fiscal austerity means spending cuts + tax increases. If Professor Alesina wants spending cuts + tax cuts, great. My fear is, his analysis will be used to support the deficits-above-all argument which will lead to tax increases on upper earners (read: entrepreneurs and investors), and maybe a VAT. (See Friday's WSJ editorial, here.)

Wouldn't lower spending help the crowding out problem? Maybe, but Larry Kudlow reports business is sitting currently on a couple of trillion dollars in cash reserves. Government isn't hoovering up all the available liquidity. Funds are lying fallow because businesses fear a double dip triggered by higher taxes and perhaps the dollar's rise against the euro.

Is rising spending causing interest rates to rise? Not right now. Treasury bonds are near record lows.

Correct policies will restore annual growth at a faster pace, reduce unemployment, and shift assets to the productive economy. Once prosperity looks like it's back, A) deficits will decline naturally, and B) the public will be far more accommodating of spending cuts and a fundamentally smaller government.