How to Reduce Deficits

The current budgetary paralysis in Washington arises from the fact that Democrats are adamantly opposed to any real spending cuts and Republicans are adamantly opposed to raising taxes. Democrats argue that "austerity," i.e., reductions in spending will retard economic growth. Republicans make the same claim about raising taxes but also argue that any increase in revenue will simply be used to protect or increase spending and thus will not do anything to reduce the growth of public debt.

Public debt is the problem. At every level of government it is putting manageable pressures on budgetary policies. Insolvent or nearly insolvent nations are dragging the European Union toward a financial precipice. The United States, if not so near the edge, is being pulled irresistibly in the same direction. One way or the other, Greek fiscal policy is going to end and "the other" is very, very bad.

The question is not whether to raise taxes or cut spending, but what combination of revenue growth and spending cuts is most likely to actually reduce public debt. Veronique de Rugy, senior research fellow at the Mercatus Center at George Mason University, directs our attention at Reason Magazine to a study that answers this question: "Large changes in fiscal policy: taxes versus spending" by Alberto Alesina and Silvia Ardagna.

For fiscal adjustments we show that spending cuts are much more effective than tax increases in stabilizing the debt and avoiding economic downturns. In fact, we uncover several episodes in which spending cuts adopted to reduce deficits have been associated with economic expansions rather than recessions. We also investigate which components of taxes and spending affect the economy more in these large episodes and we try to uncover channels running through private consumption and/or investment.

Alesina and Ardagna analyzed over a hundred attempts to reduce deficits in 21 OECD countries. They found, not surprisingly, that most of these efforts failed. It's as hard to reduce public debt as it is to reduce one's waistline, and for the same reason. What distinguishes the rare successes from the many failures is illustrated by this chart.

The left side of the chart indicates successful fiscal adjustments, i.e., those that actually resulted in a cumulative reduction in the debt to GDP ratio (4.5% after 3 years). That ratio is what really counts for fiscal stability.

The successful policies actually saw revenues decrease by a half a percentage of GDP. They cut spending by almost two percentage points. That is what works.

Nations that cut spending only modestly (.8% of GDP) while raising revenues by nearly a point and a half experience increases in the debt to GDP ratio.

There you have it. I think that some tax increases here may be unavoidable politically and suspect that they may make economic sense at least until we get back to the historically typical ratio of revenues to GDP. Nonetheless, any successful debt reduction policy has to be weighted more heavily toward spending cuts. Otherwise it will not work.

If you want to lose weight, should you increase exercise or reduce calories? The answer is yes, but the main thing is to stop eating so much. If we want to reduce the growth of public debt, let alone shrink it, and we must, we are just going to have to reduce public spending.

Comments

[Stan Gibilisco]

"The question is not whether to raise taxes or cut spending, but what combination of revenue growth and spending cuts is most likely to actually reduce public debt."

In my opinion, the real question is "Can we as a nation learn to live within our means, individually and collectively?"

If the answer is yes, we can recover.

If the answer is no, we face economic doom.

It's that simple.

[Donald Pay]

Some economists have taken apart the arguments and data presented in the study you cited.

http://www.rooseveltinstitute.org/sites/all/files/not_the_time_for_austerity.pdf

http://rortybomb.wordpress.com/2010/08/19/new-working-paper-the-boom-not-the-slump-the-right-time-for-austerity/

[Jimi]

Donald,

The Roosevelt Institutes analysis apply's several "filters" some of which are a comparison to the G7. These two analysis can not be held side by side.

[Donald Pay]

Did you read and understand any of the links, Jimi? Filters were applied by Alberto Alesina and Silvia Ardagna. The Roosevelt Institute describes the effect of those filters, ie., constricting the data in three ways that aren't really applicable to the current situation, and that obscure what the data indicates about what actually happened. Their filters obscure the fact that the cuts happened in the middle of a boom, not during a slump, and that if you look at the data without their filters it becomes clear that fiscal austerity in the middle of a slump is the exact wrong way to deal with our fiscal issues. The Roosevelt Institute study slso looked at the effects of a different, more appropriate filter.

[Mike Cooper]

We have made promises to pay that we cannot keep. All the tax raises in the world will not stop the government from increasing spending. Many local governments are headed towards bankruptcy. Greece is right around the corner. I hope I'm Chicken Little, but I doubt it.

Great article in Vanity Fair, by the way, entitled California and Bust.

[Stan Gibilisco]

We need to effect a fundamental attitude change. "The government" comprises us, the people.

All this gloom reminds me of the Ford and Carter years. I thought the whole country would end up moving south to keep from freezing in the dark.

I darn near drank myself to death in the sunshine in the Reagan years, but that's a topic for another blant (blog rant).

Point is, we recovered then, and I think we can recover now, too. We might, however, want to consider redefining the meaning of the "happiness" that we intend to "pursue."

[Ken Blanchard]

The point of the chart above is that spending cuts are more effective for reducing deficits than tax increases. Nothing in Donald's counter tells against that.

[Ken Blanchard]

The point of the chart above is that spending cuts are more effective for reducing deficits than tax increases. Nothing in Donald's counter tells against that.

[Donald Pay]

The point of the chart can be seen only if you understand that if you purposely filter out information that explains when cuts occurred, you miss the lesson. Your mistake was in not realizing the effects of the filters in your cited study. Yes, revenue increases and cuts in government should have been made--before the downturn during the Bush Presidency, not now. And cuts should be made when the economy recovers.

There should have been no Bush tax cuts. The wars should have been paid for. There should have been pay-go. There should have been tough financial regulation. This is not a "normal" business cycle downturn. This is a near depression brought on by Republican mismanagement of the economy.

[Stan Gibilisco]

Donald has a point, in my opinion. This near-depression was, in fact, brought about by Republican mismanagement of the economy! I sure hope that my colleagues in the GOP "get the message" and learn from their mistakes.

But also in my opinion, Donald oversimplifies the situation. The "original illness" (recession) was brought about by reckless behavior on the part of the "patient" (us) under an irresponsible "parent" (Bush). However, the "advancing chronic disease" (incipient depression) has deepened under the mismanagement of an incompetent "doctor" (Obama).

That said, the time for blame games ended months ago. It no longer serves any purpose to assign blame, except insofar as the guilty parties can learn from their errors and avoid repeating the same mistakes in the future.

Honestly, I don't see anybody in either party right now who has the unique combination of chutzpah and charm to lead us out of this economic mess. But we, the people, can still do it ourselves. I can change the world a little bit by changing myself ... that much I know. Multiply that by 300 million ...

[Donald Pay]

I don't think the time for pointing out who and what's to blame is over for the simple reason that we're still suffering from the same problems for many of the same reasons.

But I will say Obama is almost as hopeless an idiot as Bush. He has tried to do some things right, but he's got no spine and the Democrat Senate is hopeless. Obama is too tied to discredited Republican policy to be of much use. His stupid trade policies hand over American jobs to Columbia, South Korea, and China. He doesn't stand up for American jobs, because he's trying to be bought off by the same corporate elite that have already bought off the GOP. He's just a wannabe Republican. Our only hope is if Obama jettisons the corporate cronies and joins the middle class fight for America and American jobs. Otherwise, Stan is right. We are alone in this fight, and only can join together like the people occupying Wall Street, revolt peacefully and overthrow the whole crowd of corporate criminals and their lackeys in government.