Ryan Budget Cuts Are Based on Economic Theory Rejected by Bernanke, IMF

The jobs and housing boom promised by House Budget Committee Chairman Paul Ryan relies upon an economic theory that has been rejected by both the chairman of the Federal Reserve Board and the International Monetary Fund.

The proposal Ryan announced April 5 would make significant budget cuts starting in the fiscal year that begins Oct. 1, even as the economy contends with an 8.8 percent unemployment rate. Next year’s deficit would shrink to $995 billion from the $1.1 trillion President Barack Obama forecasts, the first step in trimming future red ink by a cumulative $4.4 trillion over 10 years. That, Ryan says, would revive housing, spark corporate investment and drive unemployment down to 4.3% by 2021.

“This budget is a jobs budget,” Ryan, a Wisconsin Republican, said this week at the American Enterprise Institute in Washington. “It sends a signal to investors, entrepreneurs and job creators that a brighter future is still possible --that America can still be the growth engine that it ought to be.”

Powering that turnaround is a phenomenon known as an “expansionary fiscal contraction,” in which private-sector growth is unleashed by a reduction in public spending. The theory of expansionary contractions, which advocates say have occurred in countries such as Canada, Sweden and New Zealand, is now a cornerstone of Republican economic policy.

The idea that cutting government spending will so improve business and consumer confidence as to cause an immediate upswing in growth finds little support on Wall Street. “Realistically, most of the evidence leans toward an adverse impact on growth in the near term,” said Michael Feroli, chief U.S. economist at J.P. Morgan Securities in New York.

‘Hit on Growth’

Nigel Gault, chief U.S. economist for IHS Global Insight, the firm whose macroeconomic model was used in a Heritage Foundation analysis commissioned by Ryan, also played down expectations of a quick acceleration. “Normally, you would expect to take a hit on growth,” said Gault, who is based in Lexington, Massachusetts.

Last month, Fed Chairman Ben S. Bernanke told the House Financial Services Committee that budget cuts “would probably lead to some reduced growth in employment in the short run.” Reductions of $61 billion in the current fiscal year, approved by the House in a largely party-line vote, would cost about 200,000 jobs and shave as much as 0.2 percentage points of annual economic growth in the first year, he testified.

Bernanke said efforts to cut the deficit would be “most effective if we did that over a time frame of five or 10 years and not try to do everything immediately.”

Long-Term Benefits

The International Monetary Fund last fall concluded that deficit-cutting does produce long-term economic benefits. A lower stock of public debt allows interest rates to fall, encouraging investment, and lower interest payments permit the government to cut taxes.

Still, reducing the size of government would carry larger short-term output and employment costs if a country could not offset the pain by lowering interest rates or if several countries simultaneously retrenched, the fund warned. And IMF economists rejected the theory of expansionary contractions.

“The idea that fiscal austerity triggers faster growth in the short term finds little support in the data,” they wrote in a chapter of the fund’s World Economic Outlook.

Obama administration officials and Republican leaders in Congress agree that the U.S. must reduce its budget deficits to avoid the risk of a financial crisis. The political dispute is over enacting significant budget cuts now, as Republicans demand, or agreeing on enforceable limits on future spending to take effect once the economy heals, which many Democrats prefer.

‘Temporary Downside’

Economists at Goldman Sachs Group Inc. likewise said last month that the $61 billion in cuts would lower annualized growth rates for two quarters by one-and-a-half to two percentage points. “The long-term benefit of fiscal consolidation comes with a temporary downside,” the New York-based firm said in a research note.

That has been the case in European nations that have embraced austerity amid concerns over governments’ ability to repay their debts. In the United Kingdom, Prime Minister David Cameron’s Conservative government, elected in May 2010, has enacted the sharpest cuts in government spending since World War II in a bid to slash the budget deficit to 1.9 percent of gross domestic product by 2015 from 11.1 percent.

Earlier this week, the U.K.’s Office of National Statistics reported that industrial output fell 1.2 percent in February. The latest figures, following the economy’s fourth-quarter contraction of 0.5 percent, “would seem to point to genuine economic weakness,” Marc Chandler, chief currency strategist at Brown Brothers Harriman & Co. in New York, said in an April 6 note to clients.

Cuts in Ireland

Ireland is in the third year of public spending cuts in a bid to shrink its budget deficit, which ballooned following an October 2008 decision to guarantee Irish banks’ liabilities. After two years of contraction, the Irish economy resumed growth in early 2010, only to shrink again in two of the following three quarters. The unemployment rate rose to 14.7 percent in March 2011 from 12.9 percent a year earlier.

Ireland featured prominently in the first academic research on the expansionary contraction hypothesis. In 1990, two Italian economists, Francesco Giavazzi and Marco Pagano, published research arguing that fiscal consolidation increased an economy’s growth rate if the private sector were convinced the government share of the economy would permanently shrink. They cited Ireland and Denmark, whose late 1980s deficit-fighting led to economic rebounds.

Boosting Spending

In the U.S., Alberto Alesina of Harvard University in Cambridge, Massachusetts, has argued that shrinking government spending eliminates concerns that consumers and businesses may have about even sharper adjustments -- including tax increases - - in the future, encouraging them to boost spending and investment.

“Many even sharp reductions of budget deficits have been accompanied and immediately followed by sustained growth rather than recessions even in the very short run,” Alesina wrote last year.

Such arguments helped shape Republican economic thinking. On March 15, the Joint Economic Committee’s Republican staff released an 18-page assessment of academic studies, including those by Alesina and Giavazzi, arguing that austerity programs based largely or entirely on reductions in government spending “may even boost the real GDP growth rate in the short term under certain circumstances.”

Joseph Gagnon, a former Federal Reserve economist, said cutting government spending now would not lead to higher growth. Historical examples of expansionary contractions, such as Ireland, “simply don’t seem relevant for the U.S.,” he said in a telephone interview.

Irish Boom

Amid a fiscal crisis in 1987, Ireland reduced its budget deficits, producing growth rates that inspired the term “Celtic Tiger.” The Irish boom was supported by devaluation of the currency, robust demand from Ireland’s trading partners and falling interest rates. “Those things aren’t going to happen for the U.S.,” said Gagnon, a senior fellow at the Peterson Institute for International Economics in Washington.

In the U.S., the Fed’s benchmark interest rate is already close to zero. The yield on the two-year Treasury bill was 0.78 percent yesterday. Key U.S. trading partners, including China, peg their currencies to the dollar. Major European economies and Japan also would be unlikely to tolerate a pronounced decline in the dollar’s value, Gagnon said.

The IMF’s October report concluded that previous academic research identifying several expansionary contractions had been flawed. Using a different methodology, the IMF reviewed 30 years of case studies and found “that fiscal consolidation typically reduces output and raises unemployment in the short term.”

‘More Painful’

A fiscal contraction equal to 1 percent of gross domestic product reduced GDP by 0.5 percent within two years and increased the unemployment rate by 0.3 percentage point, the study found. The IMF also said the economic impact of budget cuts would be “more painful” with interest rates near zero because the Fed could not cushion the blow of reduced government spending with easier monetary policy.

The fund’s economists provided support for Republicans’ preference to rely on spending cuts rather than tax increases to close future deficits.

This week, the Ryan plan suffered a setback when William Beach, the Heritage Foundation economist who directed the economic analysis, conceded that its initial unemployment estimates were wrong. On April 5, Heritage said Ryan’s deficit- cutting plan would cause the jobless rate to plunge to 6.4 percent next year and 2.8 percent in 2021, which would be its lowest level since 1953.

A day later, Heritage corrected the figures to 7.9 percent for next year and 4.3 percent in 2021. Beach said yesterday that the errant figures had resulted from a mistake in programming the IHS Global Insight model. “That kinda slipped by,” he said. “We may not have been as vigilant as we should have been.”

To contact the reporter on this story: David Lynch in Washington at dlynch27@bloomberg.net

To contact the editor responsible for this story: Chris Wellisz at cwellisz@bloomberg.net

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