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.