Cut to grow

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  • Gov spending can impact #GDP growth, but there’s another effect that Keynesians tend to ignore: the expectational effect

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  • Cutting gov #spending reduces gov activity, but this change might be offset by an increase in private activity.

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  • Kevin Hassett – “Austerity has not caused even near-term harm to countries that have undertaken it.”

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This article appears in the June 11, 2012, issue of National Review.

Austerity measures in Europe have been the topic of a heated and mostly confused debate in the economic world. During the May summit of the leading industrial nations at Camp David, German chancellor Angela Merkel and other European leaders pushed for continued European austerity. Keynesian critics argue that these policies destroy economic growth.

Economist Alan Blinder recently stated the Keynesian case concisely in the Wall Street Journal, writing that “in the short run—let’s say within a year or so—a larger deficit, whether achieved by spending more or taxing less, boosts economic growth by increasing aggregate demand.”

Supporters of austerity do not deny that government spending can have this impact on GDP growth, but they emphasize another effect that the Keynesians tend to ignore: the expectational effect. This term refers to the positive effect on consumption and investment that occurs when unsustainable government spending policies have been curtailed. Cutting government spending reduces government activity, but this change might be offset by an increase in private activity, since, no longer expecting a dramatic future tax hike, consumers and investors might be willing to spend more. The traditional Keynesian effect is the short-term negative impact that reduced government spending irrefutably has on GDP growth. If austerity measures cut spending dramatically, the question is: Which effect dominates, the expectational one or the Keynesian one? Opinions vary widely. But what do the data say?

The nearby chart is a scatter plot of data concerning changes in government spending and GDP growth in the  United States and the European members of the Organization for Economic Co-operation and Development (OECD). Since, as Professor Blinder notes, the impact of government spending on GDP growth might be spread out over a year or so, the chart plots (on the X-axis) the percentage-point change in government spending between 2009 and 2010, and (on the Y-axis) the percent-point change in GDP from 2010 to 2011. Data for 2012 are not provided because they are not available yet; Greece and Ireland are excluded because they are extreme outliers.

Click here to view a larger version of the chart.

The green regression line highlights the most important takeaway from this chart: that there is no obvious relationship between a decrease in government spending and a decrease in GDP. Keynesians would expect the line to slope upward; in fact, it slopes slightly downward. But the slope of the line is not significantly different from zero (in fact, this is true whether or not the analysis includes the two outliers, Greece and Ireland).

A possible explanation is that the two effects mentioned earlier—the expectational one and the Keynesian one—cancel each other out. GDP is lower as a result of government-spending cuts, but GDP hasn’t plummeted (except in Greece, which is a story of its own) because of the positive expectational effect, the hope of better days to come.

The chart has two policy implications. First, austerity has not caused even near-term harm to countries that have undertaken it. Second, austerity is something of a free lunch. This is because, as studies (such as a 2010 paper by economists Andreas Bergh and Martin Karlsson) show, longer-run growth is higher in countries with smaller governments. Nations that reduce spending today can do so without fearing that the longer-run growth is beingpurchased with a costly near-term recession.

Advantage Merkel.

Kevin Hassett is a senior fellow and director of economic policy studies at AEI.

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