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Required Economic Reading

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Required Economic Reading

An important new book offers clear insights about austerity policy. July 5, 2019
Economy, finance, and budgets

Austerity: When It Works and When it Doesn’t, by Alberto Alesina, Carlo Favero, and Francesco Giavazzi (Princeton University Press, 296 pp., $35)

No one would call Austerity a “fun” book—economics seldom is fun—but this is an important work for economists, policymakers, politicians, and engaged citizens. Alberto Alesina (Harvard), Carlo Favero, and Francesco Giavazzi (both of Bocconi University, in Italy) have written one of the clearest and best researched treatments of fiscal policy available. And though not quite suitable for the beach, it’s remarkably readable.

A more suitable subtitle would be “what works and what doesn’t.” For it’s the “what” rather than the “when” that really gets to the authors’ finding that higher taxes are economically more harmful than spending cuts. They show that raising taxes to close a budget deficit equivalent to 1 percent of a nation’s gross domestic product would result in a severe recession, followed by a real GDP shortfall of between 2 percent and 3 percent after several years. By contrast, a comparable cut in government outlays would spare the economy an initial setback and inhibit economic growth by only half a percent in subsequent years.

This principle holds true across a range of economies and circumstances, regardless of how government leaders employ monetary policy, exchange rates, or economic reform in labor or product markets. The authors favor statistical analyses of austerity and offer considerable guidance on which economic theories best capture reality. Their analysis casts considerable doubt on the standard Keynesian model still popular among politicians, policymakers, and academics. Conventional Keynesian thinking holds that government spending has an immediate economic impact; tax reform, meantime, has only a muted effect, filtered through business and household decisions. Keynesian economics prompted generations of policymakers to favor tax hikes, spending increases, and excessive debt burdens to boost the economy.

Austerity proposes an alternative approach. Alesina, Favero, and Giavazzi rely on a theoretical perspective, privileging supply-side effects and the impact of changing expectations as prime economic movers. They argue that cutting spending on welfare and unemployment benefits, rather than raising taxes, encourages work. Spending reductions, combined with tax cuts, foster greater consumer spending and business investment. By contrast, tax hikes fail to address deficits, depress business and consumer enthusiasm, and create expectations of continued increases.

To test these notions, the authors examine the effects of spending- and tax-based austerity on businesses and households, as well as on imports and exports. They find that businesses—oriented toward the future—demonstrate the effectiveness of outlay-based austerity efforts. Tax hikes drag down investment spending by a much wider margin than do government spending cuts. The authors found similar, though smaller, effects with households, while the effect on the trade sector was negligible.

The authors demonstrate their technical expertise in their analysis of budget policy and recessions. In an economic downturn, government revenue declines even as demands for services rise, leading to big budget deficits. But deficits naturally narrow when the economy improves. To disentangle policy effects from these cycles, the authors developed the “narrative approach,” which involves deep data mining for historical context. The statistically robust approach pools data and conducts analysis across countries and circumstances over a period of years, something seldom done elsewhere.

This broad-based econometric approach also enables the authors to go beyond pure economics and reach financial and political conclusions. They question the conventional wisdom that austerity is usually a political disaster. Sometimes it is, yes—particularly if the government relies too heavily on taxes. But they offer examples of public acceptance of austerity as a necessary evil, as demonstrated by the reelection of governments that have pursued the policy.

Unfortunately, the book’s findings, while powerful, will likely have little effect on the austerity debate. Those who favor government spending, either to protect it from austerity cuts or to use it for stimulus, are committed to bigger government, while those inclined to distrust government and resist taxation will often do so regardless of the economy’s needs. Perhaps my skepticism is misplaced, and Austerity will have an impact on policymakers—but even if it doesn’t, it should be required reading.

Photo by Dan Kitwood/Getty Images

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