This is the thinking, known in Washington as “cut and grow,” that Republicans have cited since 2010 to support their push for federal spending cuts. At times, party leaders have seemed to back away from it, warning that defense cuts could devastate the economy, for example. But the theory continues to carry large sway among conservative voters who cheered the sequester cuts and urged GOP leaders to allow them to start taking effect earlier this month.
Now, the academic godfathers of “cut and grow” say recent economic indicators are proving their theory correct. The Standard & Poor’s 500-stock index is up 9 percent since Jan. 1. Consumer spending remains higher than many forecasters expected. Nonresidential fixed investment rose by nearly 10 percent in the fourth quarter. The labor market added 119,000 jobs in January and 236,000 jobs last month.
“What could explain the booming stock markets, the latest data on private investment in the fourth quarter of 2012 and the January employment data?” Alberto Alesina, a Harvard professor who has written several papers suggesting that budget cuts done correctly can lead to better growth, wrote in an e-mail last week. “Sure the budget cuts [had] not taken place yet but investors and companies look into the future when they hire. Given that the future implies budget cuts, it must mean that they welcome them.”
To which many economists say: No. It does not mean that.
“There are plenty of other reasons why the stock market is up that have nothing to do with the U.S. budget,” said Arjun Jayadev, an associate professor at the University of Massachusetts at Boston who co-wrote an economic critique of Alesina’s work in 2010. “This is an old argument,” he added, “and I don’t think there’s any evidence that supports it.”
Alesina in recent years has written several papers, with a rotating crew of co-authors, that suggest deficit reduction that relies heavily on spending cuts and lightly on tax increases can lead to more investment and growth. His work highlights countries where growth increased after a substantial fiscal contraction, and it finds that the most successful growth rebounds occurred in countries that relied more on spending cuts than tax increases to reduce the deficit.
No advanced economy has proved Alesina correct in the wake of the Great Recession.
U.S. growth did not surge after Republicans won spending cuts in the spring of 2011, nor after they and President Obama agreed to the Budget Control Act — which eventually led to the sequester — later that year.
More broadly, the European countries that have imposed deficit-reduction measures in recent years, including Britain, Italy and Greece, have seen their economies grow much more slowly than the United States’. The Congressional Research Service has published a study challenging Alesina’s conclusions; earlier this year the International Monetary Fund’s chief economist co-authored a paper asserting that deficit-reduction measures hurt economies more than the IMF originally anticipated.
Jayadev and a co-author, Mike Konczal, challenged Alesina’s findings by noting that none of the countries he cited as successes actually reduced their deficits and stoked faster growth when the economy was slumping.
Alesina fired back in a research paper of his own in September 2010, saying “what is unfolding currently in Europe directly contradicts Jayadev and Konczal. Several European countries have started drastic plans of fiscal adjustment in the middle of a fragile recovery. At the time of this writing, it appears that European speed of recovery is sustained, faster than that of the U.S.”
In the two years that followed, U.S. growth averaged 2 percent a year. The euro zone slipped back into recession.
Cut-and-grow advocates, in academia and on Capitol Hill, contend that the reason Europe’s deficit-reduction efforts have not sparked growth is that they focused too heavily on tax increases. The sequester, many of them say, could be different.
“It makes a big difference if you implement austerity by raising taxes or cutting spending,” said Francesco Giavazzi, an Italian academic economist who co-authored a paper with Alesina last year arguing that budget cutting can lead to economic expansion. He held up Italy as an example; its austerity program relied heavily on taxes, and its economy has contracted sharply.
A successful deficit-reduction plan, Giavazzi and Alesina wrote in their paper, cuts government spending and alleviates fears of future tax hikes. Under that theory, companies observe the projected size of future deficits and figure out how much taxes would need to rise to pay them down. Their worries about those potential tax hikes discourage investment.
But if the worries go away — because spending cuts bring down the deficit and reduce the national debt as a share of the economy — the companies will ramp up investment again.
That effect won’t come overnight, Giavazzi warns. “Don’t think that by magic you will jump-start the economy,” he said. “It’s a couple of years, not a couple of months.”
Still, he and Alesina both see stock market gains as an early sign of confidence returning. Asked if the sequester cuts could trigger short-term improvements in growth, Alesina wrote: “I think they really could. Investors are worried about the debt and are waiting for a strategy of middle term debt reduction, and fiscal stability.” He said that more cuts would be even better. “Republicans should give up more on military spending and Democrats more on entitlements, especially Medicare.”
Other economists are reading the market differently. Dean Baker, a liberal economist and co-director of the Center for Economic and Policy Research, notes that the recent job gains are “way down from last winter” — the economy added an average of 113,500 fewer jobs per month in January and February than it did in the same months last year.
Bank of America researchers wrote last week that the reason many indicators look good right now is partly because the sequester is still taking effect. When layoffs and furloughs ripple through the economy in April and May, they wrote, they expect job growth to slip considerably.