What may be destroying economic recovery is not fiscal contraction, but rather lack of trust,  “Trust” is an underused word in macroeconomics. Deficit spending doesn’t induce small businesspeople to hire and expand. It scares them because they conclude the growth isn’t real and they know big tax increases are on the horizon. It doesn’t make political leaders feel better either. Lacking faith that they can wisely cut the debt in some magically virtuous future, they see their nations careening to fiscal ruin.

Alberto Alesina of Harvard has surveyed the history of debt reduction. He’s found that, in many cases, large and decisive deficit reduction policies were followed by increases in growth, not recessions. Countries that reduced debt viewed the future with more confidence. The political leaders who ordered the painful cuts were often returned to office. As Alesina put it in a recent paper, “in several episodes, spending cuts adopted to reduce deficits have been associated with economic expansions rather than recessions.”

This was true in Europe and the U.S. in the 1990s, and in many other cases before. In a separate study, Italian economists Francesco Giavazzi and Marco Pagano looked at the way Ireland and Denmark sharply cut debt in the 1980s. Once again, lower deficits led to higher growth.

Source: Marginal Revolution

The public don’t trust the politicians not to become hooked on the stimulus/inflation medicine. The result, people fear, would be high and climbing inflation, an explosion of government debt and an even bigger mess that needs cleaning up further down the line. These fears, this doubt, by the way is entirely reasonable. The same people running central banks right now are the ones who blithely walked us into this disaster in the first place, by allowing private-sector debt to explode out of control and by ignoring the most enormous asset bubbles.

In 1981 Margaret Thatcher cut UK government spending in the middle of a recession, and against the advice of 391 economists that it would worsen the recession, and UK GDP started its recovery the same quarter. In 1991 Ruth Richardson in NZ cut government spending against the advice of 15 economists, and NZ GDP started its recovery the same quarter. There are a number of other cases of expansionary fiscal consolidations, and there’s a causal theory to explain why this can happen: cutting government spending improves people’s expectations about the future of the economy and taxes, so they start investing more right now.

The point is not that aggressive fiscal policy is always bad.  The point is that there are plenty of coherent models where fiscal consolidation is better than fiscal expansion.  “Lack of confidence in a nation’s fiscal future” is a key condition for many of those models to hold.  Is that not possibly the case today?


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