The Effects Of Real Austerity

Facts Versus Ideology

By Joseph Calhoun

Matthew Melchiorre of the Competitive Enterprise Institute has a new paper, The True Story of European Austerity. The gist of the paper is that cutting both taxes and spending - true austerity - leads to higher growth. 

Austerity in Europe takes many different forms. While countries label their policies with the common term "austerity," their actions are far from similar. Only four countries in Europe have engaged in what can truly be considered austerity-cutting both spending and taxes-Bulgaria, Ireland, Latvia, and Lithuania. Instead, more countries have followed the opposite path-increasing both spending and taxes-than any other option. This does not qualify as austerity in any reasonable sense of the term. Businesses bear all the burden of fiscal consolidation while governments bear none. Contrary to popular belief, austerity is largely absent from Western Europe.

The paper breaks down austerity as practiced in Europe into 9 categories:

The results for the categories with at least 4 countries:

Well, knock me over with a feather. All this does is confirm reams of research on the multiplier effects of spending and tax changes. It also at least partially confirms the research that correlates smaller government with higher rates of economic growth. The vast majority of the research shows that tax changes have a much greater impact than spending changes and this data supports that view. Raising taxes and cutting spending or even holding spending constant is doomed to fail because they both have negative multipliers. The only way governments can raise economic growth and address their deficit problems is to cut both taxes and spending.

There is historical precedent for that in the depression of 1920 which followed WWI. President Harding cut government spending nearly in half while cutting tax rates for all income groups. The depression of 1920 lasted just 7 months. There is some contention among economists as to how much of the spending cuts were from Wilson and how much were from Harding but as far as I know no one disputes that spending was cut drastically and that tax rates were also cut. There are other differences between then and now - such as the gold standard and the conduct of monetary policy - but based on this research it appears that what worked then still works today. For another modern example, one could also point to the reforms in Canada in the 90s that essentially used the same template of lower spending and lower taxes.

So here we have a policy proven to work that would satisfy the deficit hawks and the honest Keynesians who want some kind of effective stimulus. The question everyone should be asking is if we know what works, why haven't we tried it? I'll leave you to answer that for yourself.