Another salvo in the Macro Wars. In a newish blog post, John Cochrane declares that austerity is hurting Europe:
Austerity isn't working in Europe...In addition to its direct economic costs, these “austerity” programs aren't even swiftly closing budget gaps. As incomes decline, tax revenue drops, and it is harder to cut spending. A downward spiral looms...
Europe's experience is a warning that austerity -- a program of sharp budget cuts and (even) higher tax rates, but largely putting off “structural reforms” for a sunnier day -- is a dangerous path.
Why is austerity causing such economic difficulty? What else should we do?He then declares, in keeping with much of his past writing, that stimulus would also be a bad idea:
Lack of “stimulus” is the problem, say the Keynesians...They claim that falling output in Europe is a direct consequence of declining government spending...They -- and we -- just need to spend more. A lot more.
Where will the money come from?...The U.S. can still borrow at remarkably low rates...But remember that Greece was able to borrow at low rates right up to the moment that it couldn’t borrow at all. There is nobody to bail out the U.S. when our time comes...
Lately, Keynesians have been pushing an even more audacious idea: deficits pay for themselves...
For deficit spending to pay for itself, then, $1 of spending must create more than $5 of output...[But] Keynesians made fun of “supply siders” in the 1980s, who made similar claims for tax cuts.These two points of view just don't seem consistent to me. Here's a few reasons why:
1. How can austerity and stimulus both be harmful for the economy? Cochrane clearly states that austerity is not just ineffectual, but is actively harming Europe. This is important. Because he then claims that increasing government spending (stimulus) would actively harm rich economies (by raising default risk, causing rising interest rates and crowding out). He could have argued that the level of government spending simply doesn't affect growth one way or another. But he didn't. He claimed that either slashing or boosting government spending would cause a significant deterioration from where we are right now. It doesn't take a genius to see the logical implication of this position: Cochrane must believe that the level of government spending is exactly optimal right now.
So policymakers in every rich country (including Barack Obama) have gotten the level of government spending exactly right! That's nothing short of amazing. Who says government is inefficient? ;-)
2. If austerity increases deficits, why wouldn't stimulus reduce deficits? Cochrane laughs at the notion, currently being advanced by Brad DeLong and Larry Summers, that increased government spending could pay for itself. But just a few sentences earlier, he claims that austerity is failing to close budget gaps! Again, let's apply simple logic. Draw a graph with spending on the x-axis and deficits on the y-axis - basically, a Laffer Curve for spending. If austerity and stimulus would both increase deficits, we must be at a local minimum on that graph - in other words, our current level of spending must be exactly the level that minimizes fiscal deficits. Again, a huge win for government policy!
(Now, note that Cochrane has left himself a bit of wiggle room. Instead of saying austerity is increasing deficits, he says it simply isn't "swiftly closing budget gaps." But his talk of a "downward spiral" clearly invokes the notion that a substantial amount of austerity would have the opposite of the intended effect on the fiscal balance.)
3. How does the "downward spiral" work? This isn't related to the previous two points, but I just wanted to throw it in because it annoyed me. Cochrane writes: "As incomes decline [under austerity], tax revenue drops, and it is harder to cut spending. A downward spiral looms." Wait a second. This doesn't seem like a spiral. If austerity reduces incomes, which reduces tax revenues, which prompts policymakers to enact more austerity, then that could clearly cause a downward spiral. But if falling incomes make it "harder to cut spending" - i.e., harder to enact further austerity - then the spiral should arrest itself. Right? I just don't understand how Cochrane thinks this is supposed to work.
Over the past couple of years, stimulus opponents have been relentlessly pounded by the evidence. Countries that have cut spending have performed worse. This makes it hard to argue that government spending does not affect GDP during a recession. And it makes it very, VERY hard to argue that austerity works. Basically, if you are still saying that cutting spending would boost GDP in the current recession, most observers think you are disconnected from reality.
So how do the opponents of fiscal stimulus respond? All through the recession, they've been saying that boosting spending doesn't boost GDP. But if cutting spending hurts GDP, how is the anti-stimulus position tenable? Well, stimulus opponents could argue that government spending is simply irrelevant - that the correlation on the spending/GDP graph does not equal causation, and that the countries who enacted more austerity simply happened to be the ones that were hit by worse shocks to begin with. But like I said, that's proving a difficult case to make.
The only other out for stimulus opponents is to claim that we are at the perfect level of government spending right now - the level that maximizes GDP and minimizes deficits at the same time. If this is true, then austerity and stimulus would both be bad. But I have to say, this case doesn't seem credible either. How is it that every rich country just happens to be at exactly the right level of spending?
Cochrane's post goes on to extol the virtues of long-term structural reforms. I have no problem with that (though the reforms I'd suggest might be very different from his). But isn't it a bit beside the point? You can't have your anti-stimulus cake and eat it too! Opponents of government spending have been forced to bow before the overwhelming weight of evidence that cutting spending has been bad for GDP. But they still refuse to accept the logical implication of that evidence, that boosting spending would have boosted GDP. I just don't get it.