Austerity and Economic Growth: Keynesianism didn't work so well in Europe

Paul Krugman told MSNBC
“We have actually had a massive unethical human experiment in austerity doctrine.  Here we have had this view that cutting government spending is going to be good for the economy even when the economy is deeply depressed and we have put it into effect in large parts of Europe and we have put it into effect to a significant effect in the US . . . . And the results have been exactly what someone like me said that they would be, which is there has been a very depressing effect on the economy.  Where is the evidence that this other view is at all right?”
Unfortunately, it looks as if Romney is inconsistent with his views on government spending, though it is possible to rationalize this quote by saying that changing spending will temporarily create frictional unemployment. From an interview in Time Magazine:
Halperin: I want to get to a lot of those, and let’s go to spending, which is a big thing for you, one of the bases of comparison – you say you’d cut spending a lot more than the President has.  And like most governors I know, you can get down in the detail.  A lot of people don’t know that about you; you can really get your arms around a policy issue and go deep, so let’s talk about spending.  You have a plan, as you said, over a number of years, to reduce spending dramatically.  Why not in the first year, if you’re elected — why not in 2013, go all the way and propose the kind of budget with spending restraints, that you’d like to see after four years in office?  Why not do it more quickly? 
Romney: Well because, if you take a trillion dollars for instance, out of the first year of the federal budget, that would shrink GDP over 5%.  That is by definition throwing us into recession or depression.  So I’m not going to do that, of course.  What you do is you make adjustments on a basis that show, in the first year, actions that over time get you to a balanced budget.  So I’m not saying I’m going to come up with ideas five or ten years from now that get us to a balanced budget.  Instead I’m going to take action immediately by eliminating programs like Obamacare, which become more and more expensive down the road – by eliminating them, we get to a balanced budget.  And I’d do it in a way that does not have a huge reduction in the first year, but instead has an increasing reduction as time goes on, and given the growth of the economy, you don’t have a reduction in the overall scale of the GDP.  I don’t want to have us go into a recession in order to balance the budget.  I’d like to have us have high rates of growth at the same time we bring down federal spending, on, if you will, a ramp that’s affordable, but that does not cause us to enter into a economic decline. . . . 

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Blogger Daniel McKay said...

You fail to establish a causal link, the data you use is highly endogenous and is as one would expect if you were to think about the problem.

Governments tend to increase spending when the economy is expected to slump (stimulus), therefore it is 100% expected that if you simply regress GDP growth and spending growth that they would be inversely related. Instead you need to control for pre-existing estimates or something else that would perhaps give strength to your results.

It is a simple statistical fallacy.

10/02/2012 8:17 PM  
Blogger John Lott said...

I also have a piece at RealClearMarkets that talks about spending lowering the next year's employment and income. http://www.realclearmarkets.com/articles/2012/07/16/austerity_works_its_time_to_give_it_a_try_99764.html

10/02/2012 9:58 PM  
Blogger Daniel McKay said...

It appears though however both pieces suffer from the same methodology. You cannot simply regress these outcomes together and pretend the link is causal.

I also note that by spending money you, "by necessity", take money that could be spent away from the private sector. You fail to recognize in that piece that we are living in a global space where bonds can be bought by foreigners and thus we do not see a squeezing of the private sector. Furthermore, one would likely argue that since people are investing in T-bills at negative real interest rates (yes, negative) that these are the same people who will not invest/consume that money.

In the coming days I have an article scheduled to come out on my site (http://ideafart.com) that takes the opposite stance you do.

10/02/2012 10:44 PM  
Blogger Alexander Adams said...

When you increase spending through stimulus the government incurs deficits. The government--rarely big on spending cuts--increases taxes. This caused less private consumption and a Recession. Keynesian economists would say another stimulus, but then the cycle continues. Also remember a stimulus isn't new money, it means its money others can spend but the person giving it can no longer do it , meaning its more of a false security.

Another paradox is again related to the debts incurred by spending. This increases interest rates and therefore private debt. That lowers consumption and again another recession. Just another paradox.

Now Mr. Lott does fall into the causation/correlation fallacy, however my points above rationalize the correlation (why more spending can't help) reducing that margin of error.

Also note Germany--which has refrained from these reckless policies--is almost literally finding Europe. Liberals simply can't argue the point anymore.

Mr (Dr?) Lott, I have a side question. I know you're an economist and graduated from UCLA. What economic school of thought do you belong to? I presume Chicago school as UCLA has many of those. Correct me if I'm incorrect.

11/25/2012 12:48 AM  
Blogger Daniel McKay said...

Well assuming that stimulus spending is conducted during a recession I doubt it "causes" a recession.

Spending can come in many forms, if it is targeted and temporary in nature (funding temporary research projects etc) you don't have the problem as they are not actually part of the ongoing budget.

But lets for the sake of argument say that the government just gets big and likes being big. If the economy does better, that is GDP increases as a result of spending (as it should) and the government keeps tax rates equal, the deficit will shrink and they will not be forced to raise taxes to cover it. (The US is an example of a country who can hold a debt indefinitely). As your GDP increases at a rate faster than the debt the Debt-to-GDP ratio shrinks. Thus, even with a deficit the problem doesn't get worse.
(Btw, we know that the government doesn't like cutting spending just about as much as it likes raising taxes) I'm also ignoring that our debt is held in our own currency.

Now, as you probably know, crowding probably won't occur when unemployment levels and savings levels are high. Because businesses are not investing at potential (high unemployment) and people are saving money, there is excess money that is not being used for investment. Government spending some of that money is a good thing.

We are currently experiencing historically LOW interest rates (in fact, they are negative) on treasury bills. So the debt and interest rates is a handy rule but not a law.

If you could, explain the Germany thing to me. I'm not an expert, but I think if you looked at its fiscals, growth trajectory, policies widely implemented (disallowing layoffs in favor of increased vacation etc.), and perhaps more importantly the fact that they are stressing fiscal austerity on others (they don't need it as they were already much better positioned, but if other countries don't tighten their belts Germany will get hit.) I think you might come to a different conclusion, or reason that perhaps Germany isn't a great example (other motivations, other results)??

11/27/2012 12:45 AM  

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