For Immediate Release: October 20, 2010
: Alan Barber, (406) 646-6477

WASHINGTON, DC- With unemployment hovering near 10 percent and no projections of a rapid decline, many economists advocate additional stimulus to move the economy back towards full employment. However some economists, who have received considerable attention in policy circles, argue that fiscal austerity is the best path for restoring growth and employment. A new report from the Center for Economic and Policy Research examines this argument and concludes that it does not fit the current conditions in the U.S. economy.

“In making the argument for fiscal austerity, some have claimed that pushing for lower deficits rather than stimulus spending is a better route for restoring growth,” said Dean Baker, author of the report. “However, the severity of the Great Recession in the United States means that austerity policies would almost certainly result in further contraction of the economy.”

The paper, “The Myth of Expansionary Fiscal Austerity,” points out that the argument for austerity being expansionary depends on austerity leading to a reduction in interest rates. This, in turn, is supposed to lead to increased investment and an improved trade situation as a result of the decline in the value of the currency. The study then turns to recent research by Broadbent and Daly of Goldman Sachs, which builds upon the work of Harvard economist Alberto Alesina, suggesting that fiscal austerity, particularly fiscal adjustments focusing on cuts in government spending, have been successful in fostering growth.

The CEPR report examines the conditions in the successful countries cited by Broadbent and Daly. It points out that none of these countries faced as severe a downturn as the U.S. is currently experiencing, which means that they did not have nearly as many idle resources at the point when they turned to fiscal austerity. In addition, all of the countries had much higher interest rates when they undertook their adjustment, so that there was more room for interest rates to fall following a reduction in the government deficit.

Baker also highlights the fact that of the fiscal adjustments in the Broadbent and Daly study that resulted in growth, all six took place in the context of a healthy world economy, which is clearly not the case at present. These adjustments also took place in countries that were more heavily involved in international trade than the United States is currently.  This meant that a reduction in the value of the currency (an unlikely response to fiscal austerity in the United States) would have a much larger impact on GDP growth.

In short, the paper shows that conditions that currently exist in the United States suggest that a move towards fiscal austerity is unlikely to boost growth.

The full CEPR study can be found here.