The effect on growth of getting the finances under control

June 10, 2010 1:29 PM

Some commentators argue that we can't cut spending, and need to keep borrowing, because cuts will endanger economic growth.  There are two big problems with that logic, which I've discussed on this blog repeatedly.

First, high spending undermines the trend rate of economic growth.  That is well established throughout the economic literature.  Our research has found that, based on the size of that effect found by major studies, the trend rate now might be 1.53 percentage points lower because of the growth of spending over the last decade.  It is easily possible that long term effect is outweighing any Keynesian 'stimulus'.

Second, everyone knows that all this borrowing isn't going to last forever.  A sustainable recovery will need a pick up in business investment.  But investment will be depressed if businesses and investors think that their returns tomorrow will face higher taxes to pay for today's borrowing.

The well-read Marginal Revolution blog looks at this issue today, one of their commenters points to this study - which shows how two big cuts in borrowing in European countries were followed by a recovery - and makes the point very well:

"...in 1981 Margaret Thatcher cut UK government spending in the middle of a recession, and against the advice of 391 economists that it would worsen the recession, and UK GDP started its recovery the same quarter. In 1991 Ruth Richardson in NZ cut government spending against the advice of 15 economists, and NZ GDP started its recovery the same quarter. There are a number of other cases of expansionary fiscal consolidations, and there's a causal theory to explain why this can happen - see http://ideas.repec.org/p/cpr/ceprdp/417.html (shortly, it's that cutting government spending improves people's expectations about the future of the economy and taxes, so they start investing more right now). Of course, correlation does not prove causation, and perhaps there is something about the EU countries now that is so different as to the cases I cite as to make those results no longer likely to hold, but Krugman writes as if he has forgotten entirely about the 1980s and 1990s."

Some commentators argue that we can't cut spending, and need to keep borrowing, because cuts will endanger economic growth.  There are two big problems with that logic, which I've discussed on this blog repeatedly.

First, high spending undermines the trend rate of economic growth.  That is well established throughout the economic literature.  Our research has found that, based on the size of that effect found by major studies, the trend rate now might be 1.53 percentage points lower because of the growth of spending over the last decade.  It is easily possible that long term effect is outweighing any Keynesian 'stimulus'.

Second, everyone knows that all this borrowing isn't going to last forever.  A sustainable recovery will need a pick up in business investment.  But investment will be depressed if businesses and investors think that their returns tomorrow will face higher taxes to pay for today's borrowing.

The well-read Marginal Revolution blog looks at this issue today, one of their commenters points to this study - which shows how two big cuts in borrowing in European countries were followed by a recovery - and makes the point very well:

"...in 1981 Margaret Thatcher cut UK government spending in the middle of a recession, and against the advice of 391 economists that it would worsen the recession, and UK GDP started its recovery the same quarter. In 1991 Ruth Richardson in NZ cut government spending against the advice of 15 economists, and NZ GDP started its recovery the same quarter. There are a number of other cases of expansionary fiscal consolidations, and there's a causal theory to explain why this can happen - see http://ideas.repec.org/p/cpr/ceprdp/417.html (shortly, it's that cutting government spending improves people's expectations about the future of the economy and taxes, so they start investing more right now). Of course, correlation does not prove causation, and perhaps there is something about the EU countries now that is so different as to the cases I cite as to make those results no longer likely to hold, but Krugman writes as if he has forgotten entirely about the 1980s and 1990s."

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