[Disclaimer: Bob Wenzel doesn't like me using the term "fiscal austerity," since he thinks the public associates it with jacking up taxes and cutting social programs in order to bail out bankers. He has a point, but it will just get too cumbersome in this post if I try to come up with some alternate term. So, when I speak approvingly of "fiscal austerity," all I mean is the government cutting its spending in order to reduce deficits. Also, I would like to thank the supportive von Pepe for encouraging me to write up this post.]
In my latest EconLib article, I show that the peer-reviewed economic literature is far friendlier towards “expansionary austerity”–the idea that reining in budget deficits through spending cuts can actually boost economic growth, even in the short term–than prominent Keynesians would lead you to believe. (David R. Henderson thinks it’s “one of [my] most important” EconLib articles yet, and recent events have proven that David’s model of the world is spot-on.)
Lars Christensen at the Market Monetarist blog generally likes my article, except he thinks I am ignoring the crucial role that monetary policy plays in all of this:
The Danish and Irish cases are hence often highlighted when the case is made that fiscal policy can be tightened without leading to a recession. I fully share this view. However, where a lot of the literature on expansionary fiscal contractions – including Bob’s mini survey of the literature – fails is that the role of monetary policy is not discussed. In fact I would argue that Denmark was a case of an expansionary monetary contraction – a the introduction of new strict pegged exchange rate regime strongly reduced inflation expectations (I might return to that issue in a later post…).
In all the cases I know of where there has been expansionary fiscal contractions monetary policy has been kept accommodative in the [sense] that nominal GDP – which of course is determined by the central bank – is kept “on track”. This was also the case in the Danish and Irish cases where NGDP grew strong through the fiscal consolidation period.
My view is therefore that that fiscal austerity certainly will not have to lead to a recession IF monetary policy ensures a stable growth rate of nominal GDP. This in my view mean that we will have to be a lot more skeptical about austerity for example in Spain or Greece being successful….
All the cases of expansionary fiscal consolidations I have studied has been accompanied by a period of fairly high and stable NGDP growth and the unsuccessful periods have been accompanied by monetary contractions. My challenge to Bob would therefore be that he should find just one case of a expansionary fiscal contraction where NGDP growth was weak… [Bold added.]
Now right off the bat, look at how loaded the deck is, in favor of the market monetarists. Of course, if they’re right then it doesn’t matter that the deck is loaded; they should still win the argument. But if they’re wrong–which I think they are–it makes it hard for me to prove it.
What do I mean? Well, suppose a new president (perhaps a fan of this blog) takes office in a small country and (a) cuts government spending by 30% in one year and income taxes by 15%, in absolute terms, and (b) abolishes the central bank and ties its currency to gold. A large budget deficit is transformed in one year into a modest surplus. Further suppose that my wacky Austrian views happen to be right–and Lars/Scott Sumner are utterly wrong. What happens?
Well, because I’m right (by stipulation), the real economy is just fine. There might be an initial period where the official unemployment rate in the country shoots through the roof, because workers have to move out of government (or government-subsidized) sectors, and into purely private sectors. But the big tax cuts and stability provided by the new gold standard, as well as the drop in government borrowing, lead to a fall in interest rates and a surge in private investment and job creation. Within 6 months, the unemployment rate is below the level at the start of the policy change. For the year, real GDP is up 8% when all is said and done, while consumer prices fall 2%.
Now I would look at this as a stunning refutation of Lars’ views, and a great counterexample. But he would look at the figures and say, “What do you mean Bob? Clearly maintaining aggregate expenditures was crucial for that giant reduction in government spending to work out. Nominal GDP rose 6% during the year, and interest rates fell. It was only the relatively loose monetary policy that offset the fiscal contraction.”
Does everybody see what I’m saying? Lars has defined “accommodative monetary policy” in such a way that I would have to find a government that simultaneously slashed spending while deliberately engineered massive price deflation. If the market monetarists are wrong, then it means a government could enact very tight restrictions on monetary inflation–perhaps going back on gold–and yet their own metric would classify that as “not tight” so long as the economy didn’t collapse. That is not a good way to think about these issues, especially since the very issue under dispute is whether the market monetarists are right.
Furthermore, it’s not even an absolute value of NGDP growth that’s at issue. If I understand Sumner’s worldview, the reason “NGDP matters” is that workers and firms sign contracts that have nominal values. So, suppose I find an example from 1880-82 where a European government slashes spending by 30%, and the economy doesn’t falter. Furthermore, NGDP is flat throughout the period. Did I just win? No, because Sumner can say, “Hang on, this country was on the gold standard. For the prior decade, prices had generally fallen about 2% per year, and real growth was 3% per year, so NGDP growth was only 1% per year. Thus, NGDP being flat from 1880-82 was only 1 point below trend per year. Compared to the fiat money era, flat NGDP would indeed be scandalous, but back then it wasn’t that far below the norm, and so people’s nominal debt burdens wouldn’t have been much harder to service.” (I’m making up the numbers for this hypothetical 1880-82 scenario, but I’m just showing how incredibly difficult it would be to actually find a counterexample to the Sumnerian explanations.)
Finally, as an Austrian economist who endorses Misesian business cycle theory, I admit upfront that it’s going to be hard to find a deliberately contractionary fiscal and monetary policy, leading to economic expansion even in the short term. That’s because I explain recessions as due to a switch from loose to tight money, where I define those terms differently from how a market monetarist would.
I’m not going to give a perfect counterexample–since, as I explained above, that would almost be impossible in principle, even if the market monetarists are totally wrong–but World War II offers something pretty close. Let’s work through two graphs and see why.
This first graph shows the level of NGDP, current government expenditures (note that this isn’t the same thing as “how much money did the government spend those years?” but it’s close enough), and the monetary base. Notice that I put the monetary base on the right axis, so you could see it better.
In the next graph, I’ll show the same three variables, but this time as an index=100 at 1938 (and now of course they’re all on the same axis):
Now this is really the killer chart. From 1945-46, clearly there was a more severe contraction in fiscal policy, than a corresponding looseness in monetary policy, if we are going to use those terms in a way that is useful in refereeing the claims of the market monetarists. Furthermore, coming off of five years of rapid NGDP growth, now it is flat.
Of course, the obvious MM response is to say, “Right! And notice there was a recession right then, just like we’d predict.”
But the free market camp can’t have it both ways. We’ve been congratulating ourselves for years now on how the Keynesians were wrong for predicting a postwar depression. (Look what our gloating did to poor Daniel Kuehn.)
Now if we move on to the next year, 1946-47, it’s very interesting. Just eyeballing the chart it looks like government current expenditures (again, this term doesn’t mean what you probably think–I ran into this issue on a major paper last year) fell about 15 percent, the monetary base was about flat, and yet nominal GDP growth was quite strong (in percentage terms). So I’m guessing Lars would say, “Right, accommodating monetary policy!” even though the monetary base growth came to a screeching halt after half a decade of rapid growth.
I don’t have good NGDP figures, but I imagine you would find the same pattern–perhaps even more so–if you looked at the end of World War I, where the Fed engaged in unprecedentedly tight monetary policy, and the government slashed spending tremendously. (I give the stats here.) Yes, there was a sharp depression, but it was soon over and paved the way for the Roaring Twenties.
I admit I have not found the smoking gun Lars wanted, but I hope I’ve shown why that is almost impossible, even in principle, given that I believe in Austrian business cycle theory. In any event, market monetarists shouldn’t ever roll their eyes at Keynesians who refuse to see the difficulties that particular historical eras provide for their theories. This is because from my perspective, both camps have a tough time explaining why the US bounced back so quickly after 1920-21 and 1945-46, if their explanation of 1929-1939 is correct.