Myth of the Day: Austerity in the Form of Spending Cuts Will Harm Growth and Employment
The recent debates in state and federal government regarding overspending and massive deficits during a period when the economy is sluggish makes this fiscal policy myth particularly timely. Today’s myth directly addresses hand-wringing over budget cuts during a recession. Dr. Fruits and Dr. Pozdena, co-authors of Tax Myths Debunked, detail the evidence that thoughtful austerity can stimulate economic growth rather than harm a recovery.
Even during a period that so many Americans are tightening their belts and forging ahead with a leaner budget, the mere mention of budget cuts still sends many policymakers and pundits in D.C. and state capitols around the country into crisis mode. As former U.S. Senator Phil Gramm recently pointed out in The Wall Street Journal, any threat of cuts invokes what has become known as Washington Monument Syndrome where policymakers claim that any cut—even simply cuts to the rate of growth—will result in beloved public parks being closed, public safety being compromised, and essential services cut across the board. Often, as in the case of the recent sequester, the government is required to operate with a lower rate of spending growth or in the most severe situations, a budget figure that matches spending from only a few years previous to cuts.
More broadly, Dr. Fruits and Pozdena point out that cuts to government need not negatively affect economic growth or employment. The economy is more complex than basic Keynesian fiscal models driven only by spending predictions. The authors point out that the key is the specific structure of austerity models:
The literature suggests that the secret to successful austerity measures is to combine spending cuts with tax cuts, not tax increases. The reason is that, if both cuts are credible, then consumers and investors will have more confidence that expansionary monetary policy will lower interest rates and that future taxation will be less onerous. The resulting reduction in taxes, interest rates and the increased resources in private hands are then more likely to stimulate added investment and work effort. Unless the public sector labor that is initially idled by the spending cuts is completely unproductive, they will be drawn quickly into the expanded and more productive private sector.
Practical experience suggests that Dr. Fruits and Dr. Pozdena are correct. After the end of World War II, many policymakers and political observers predicted that the massive drop in government spending that was the result of the post-war military drawdown would lead to massive economic contraction on the heels of the Great Depression. These policymakers and political observers were proven wrong. As economist David Henderson points out in his seminal study of the period:
Over those years [the post-war years from 1944-1948], the U.S. government cut spending from a high of 44 percent of gross national product (GNP) in 1944 to only 8.9 percent in 1948, a drop of over 35 percentage points of GNP. The result was an astonishing boom. The unemployment rate, which was artificially low at the end of the war because many millions of workers had been drafted into the U.S. armed services, did increase. But between 1945 and 1948, it reached its peak at only 3.9 percent in 1946. From September 1945 to December 1948, the average unemployment rate was 3.5 percent.
The authors clearly establish that austerity need not be feared if structured correctly. Economic theory and the incredible natural experiment of the post-World War II economy informs policymakers that cuts can and should be made to bloated government budgets, even in a time of high unemployment.
Government spending is not the driver to economic growth. The key ingredients to recovery and strong economic growth continue to be strong policy fundamentals that incentivize hard work, ingenuity, and innovation.
To read more about the relationship between stimulus spending and its effect on an economy during a recession, check out Tax Myths Debunked. Co-authors Dr. Pozdena and Dr. Fruits use overwhelming evidence to confirm that the path to prosperity is in free-market, pro-growth policies. The report is available for free download at www.alec.org/tax-myths-debunked.