LL: Your economic study's final conclusion was spending cuts work where stimulus fails. Can you go into some detail on that?
KB: Over the last four decades, a number of other countries with developed economies like ours have gotten into financial trouble by running large government budget deficits and accumulating an excessive level of government debt as a percentage of their GDP. We can learn what economic policies work and what ones fail from their experiences.
In the most comprehensive study of fiscal consolidations and their results, Harvard University professors Alberto Alesina and Silvia Ardagna examined 107 large fiscal adjustments in 21 OECD member-countries (**see list at end of story) from 1970 to 2007.
According to Alesina and Ardagna, a successful fiscal adjustment is where the government debt-to-economy ratio drops by at least 4.5 percentage points three years after the beginning of a fiscal adjustment. Alesina and Ardagna identified 21 successful episodes in 10 countries and concluded that these successes were based predominately or entirely on government spending reductions.
Alesina and Ardagna stressed that these efforts where based predominately or entirely on government spending reductions may even help grow economies in the short term. Alesina and Ardagna defined growth as where a country jumped into the top quarter of all developed countries in terms of economic growth for the three years following the start of spending cuts. They found 26 such instances of short term economic expansion in nine countries.
The three case studies in the JEC Republican staff report—Canada, Sweden, and New Zealand –also demonstrate that when governments that have accumulated excessive government debt as a percentage of their economy begin to make credible spending cuts, business investment rebounds as fears of higher taxes recede and confidence increases. In turn, higher business investment boosts real growth and job creation.
LL: We have all heard you can't spend your way to prosperity. How can you cut your way to prosperity?
KB: High government spending, persistent government budget deficits and a rising government debt (1) create expectations of future tax increases to service the debt and (2) add to the uncertainty about the overall performance of the economy in the future.
- For businesses, government budget deficits and rising government debt reduce the expected after-tax rate of return on new investments. Consequently, businesses make fewer investments in buildings, equipment, and software. Since business investment is the main driver of economic growth and job creation, less business investment means slower economic growth and fewer private sector jobs.
- For families, government budget deficits and rising government debt creates uncertainty about their economic prospects.
Consequently, families are less likely to make major purchases of such things as homes and vehicles.
Lowering the government debt-to-GDP ratio by reducing government spending without increasing taxes changes these expectations and reduces uncertainty in the short term. Consequently,
- Businesses will invest more in buildings, equipment, and software. Moreover, businesses will hire more people to work in their new facilities or with their new equipment and software.
- Families will be more willing to make major purchases.
Thus, the changed expectations about future taxes and reduced uncertainty from cutting government spending mean faster economic growth and more private sector jobs in the short term.
LL: What do you say to those who say cutting spending will curtail jobs?
KB: There is a large correlation between business investment (i.e., non-residential fixed investment) and the change in private nonfarm payroll employment, while there is a small negative correlation between federal government consumption and investment spending and the change in private nonfarm payroll employment. Put simply, business investment—not federal government spending—drives job growth.
The most important job-related question is not whether reducing federal spending may cause some reduction in government payrolls, but how federal spending affects business investment. Indeed, there is an inverse relationship between federal spending and the unemployment rates. A high level of federal spending is generally associated with slow job growth and a high unemployment rate.
LL: How big of a risk is delaying the spending cuts?
KB: The current fiscal condition of the U.S. government is perilous.
During fiscal year 2011, the CBO projects that federal spending will be 24.7% of Gross Domestic Product, well above the average of 19.4% of GDP for fiscal years 1947–2007. It is also expected to remain far above its post World War II average for the next decade. The United States cannot maintain this level of federal spending—let alone allow it to escalate—without seriously damaging its economy. The abundant empirical evidence is clear and irrefutable; increasing federal spending slows economic growth.
Obama Administration officials have emphasized the risk of starting a fiscal consolidation program now while ignoring the risk of delay.
There are significant external risk factors to the U.S. economy in both the short run and the long run that cannot be foreseen, such as:
(1) resurging price inflation, (2) loss of confidence in the U.S.
dollar as the world’s reserve currency, (3) euro-zone sovereign debt defaults, and (4) war in the Middle East. But, the United States will be in a better position to respond to any of these challenges by reducing federal spending sooner rather than later.
LL: How much will this delay cost the American taxpayer?
KB: The risks of delay are large and increasing, but are difficult to quantify.
**OECD member-countries: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom, and the United States
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A Senior Talent Producer at CNBC, and author of "Thriving in the New Economy:Lessons from Today's Top Business Minds."