As Republican leaders urge a steep and swift reduction in government spending, they are making an unorthodox argument: that these cuts would strengthen economic growth not only in the distant future but almost immediately.
That view is at odds with many of the nonpartisan groups that analyze the economy. Research departments of leading banks and agencies such as the Federal Reserve and the Congressional Budget Office warn that deep cuts would come at the cost of weaker growth and fewer new jobs in the months ahead, as less public money is pumped into the economy.
“There’s another myth I need to address,” House Speaker John A. Boehner (R-Ohio) said in a speech this month, “and that is the myth that addressing our debt challenges requires ‘pain.’ ”
This debate — over the impact of immediate budget cuts on a fragile economy — is at the core of a showdown over how and when to trim the deficit. It puts Republicans, who control the House, at odds with the White House and Democrats, who control the Senate.
Both sides agree that over the long term, yawning budget deficits put the country in danger, especially if investors fear that the federal government won’t be able to pay its debts and demand sharply higher interest rates in return for continuing to lend Washington money.
But Republicans, in warning that federal deficits also pose an immediate hazard, are mustering two other arguments. The first turns on the question of business confidence, positing that companies are afraid they will pay the cost of the rapidly rising national debt through higher taxes. This fear makes them reluctant to hire and invest. So cutting government spending will make firms again confident enough to invest and expand, the argument goes.
A second argument, which Republican politicians have embraced but many conservative economists shy away from, is that borrowing by the government is crowding out investment by firms.
In effect, conservatives are now rejecting “root-canal economics,” which many embraced in the 1970s and ’80s. At the time, they argued that some immediate pain was necessary for a stronger growth in the long run.
Today, conservative economists still acknowledge that lowering spending would reduce some economic activity. But they argue that budget cuts, by enhancing business confidence, would partly, if not fully, offset that drag.
“Business spending is a long-run decision that requires an environment that will be beneficial going forward,” said Douglas Holtz-Eakin, president of the American Action Forum and an economic adviser to John McCain’s 2008 presidential campaign. “You have the administration signaling they’re going to solve our fiscal problems by taxing those who do that kind of investment. But if instead you signal your seriousness by doing it through spending cuts and doing it now, the business environment will be better.”
The theory has backing in research by Alberto Alesina, a Harvard economist, examining the economic performance of countries that have reduced previously high budget deficits. Alesina makes relatively cautious claims about what his data prove and the implications for U.S. policy. He acknowledges, for example, that the historical data he has analyzed offer only an indication, not a definitive prediction, of how sharp budget cuts would affect the U.S. economy.
“The simple idea that tightening leads to recession and more spending leads to more growth are not true in a situation where people feel worried about deficits,” he said in an interview.
Many economists are skeptical of those conclusions. A group of economists at the International Monetary Fund led by Daniel Leigh have done their own historical analysis that shows, in part, that the economic toll from from budget cuts is greater when a country’s central bank doesn’t soften the blow by cutting interest rates.
The U.S. Federal Reserve has already cut its target interest rate to near zero and taken other exceptional steps to support growth. As a result, if there are steep, immediate budget cuts in the United States, there isn’t much the Fed could do to offset any economic damage.
The second argument, which concerns the “crowding out” of private investment, is more commonly made by GOP politicians than by conservative economists.
Republicans argue that trimming the deficit would have immediate economic benefits, as less government borrowing would leave more capital available for private firms to use to invest. Boehner made essentially that argument in a May 9 speech, stating that federal spending was “crowding out private investment and threatening the availability of capital needed for job creation.”
But in today’s marketplace, interest rates are near all-time lows already and aren’t preventing companies from borrowing. Moreover, firms have record sums of cash socked away on their balance sheets ready to be invested.
For policymakers who share the conservative economists’ view that budget cuts would spur a rise in business confidence that offsets their negative effect on economic activity, the question is: What sort of budget cuts would be most beneficial?
Kevin Hassett, a resident fellow at the American Enterprise Institute, says that the evidence from economic research points toward cutting transfer payments to individuals, such as Social Security and Medicare benefits, while preserving spending that creates public resources such as roads and bridges. And he argues that spending cuts should be phased in gradually.
“What we know from the data is that when you have credible deficit reduction phased in so that the reduction in spending on roads and so on are minimized, and leans heavily on reducing entitlement spending in the future, you can at the very least get through the restructuring without growth slowing,” Hassett said. “You can even hope for some upside.”