The best medicine can taste awful.
The governments of the U.K., Ireland and Greece have embarked upon ambitious, sometimes painful efforts to restore their economies to sustainable growth paths. Of the three, the U.K. and Ireland took their medicine, following the lessons of past efforts to pull national economies away from spiraling debt. Greece decided the taste was just too awful, and its irresponsibility threatens every euro-zone country.
The history of the modern welfare state is replete with examples of fiscal calamities. In good times, politicians expand government spending as far as soaring revenues will let them. In bad times, when the bubble bursts, countries find themselves in a ditch.
Numerous fixes have been tried over the years, and economists have created a cottage industry studying them. What has emerged is a consensus about what works, a consensus that is about as strong as any in the macroeconomics literature.
The antidote to fiscal crisis is fiscal consolidation, a dramatic change in spending and tax policy that reduces the indebtedness of a nation. Such consolidations have relied on varying degrees of tax increases and spending reductions. Some have successfully reduced debt, some haven’t. The data tell a clear story: What works is cutting government spending.
A series of influential papers by Harvard University economist Alberto Alesina and various co-authors found decisive evidence that successful consolidations rely almost exclusively on spending reductions, while unsuccessful consolidations seek to close 50 percent or more of the gap with tax increases.
Cutting Is Key
A recent study by the International Monetary Fund supports the principle that cuts, particularly to entitlement programs, are key.
Of the budget consolidations examined by the IMF, those that met the goal Alesina laid out in his latest paper -- a 4.5 percentage-point reduction in the ratio of debt to potential gross domestic product -- did so with spending cuts that were about twice as big as tax increases. Cuts to pension and health entitlements had the most beneficial effect on economic growth.
Tax increases fail to achieve sustained debt reduction for two likely reasons.
First, they increase the risk that an economy will experience a double-dip recession. Second, they illustrate that the offending government is unwilling to take a tough stand against soaring entitlements. A welfare state that can’t shrink in a recession will possibly never shrink, which means that today’s high taxes provide an ominous foreshadow of even higher rates to come.
Spending reductions succeed because they provide a credible assurance that the debt Leviathan will not swallow the entire economy, increasing optimism and encouraging current investment. They also suggest lower future tax rates, which increases the perceived wealth of consumers, driving up current consumption. And they provide central banks leeway for expansionary monetary policy that tax hikes, which can increase measured inflation, do not.
So back to the crisis at hand.
To their credit, the U.K. and Ireland have pegged the spending-cut share of their overhaul almost precisely at 66 percent, matching the average share I calculated for successful consolidations in the IMF study. Greece, on the other hand, seeks to close its budget gap with more tax increases than spending cuts.
Greece’s efforts are almost sure to fail.
The U.K. gave itself a strong chance of success by prioritizing spending cuts over tax hikes. My one caution is that the emphasis on reductions is a good deal smaller than Alesina’s findings support.
Ireland’s outlook is more complicated. While the Irish clearly relied on history’s lessons, this doesn’t guarantee success.
In the IMF study there were six countries with successful consolidations. (The top three were Sweden in 1996, Finland in 1996-1998 and Belgium in 1993.) None of those was a country that, like Ireland today, shares a common currency with a large number of other nations. This may be a crucial distinction.
The IMF’s analysis suggests that accommodative monetary policy, currency devaluation and surging exports play major roles in helping a nation adjust to tighter fiscal policy and sustain the economic growth that drives budget gains. In all three of those areas, membership in the European Union ties Ireland’s hands.
Moreover, since Greece and Ireland both use the euro, their individual assaults on debt might best be thought of as a united effort. If we combine the Greek and Irish plans into one, it falls far short of the spending-cut targets supported by the IMF data and is light years away from those of Alesina and his colleagues.
As the U.S. plans its next moves in the face of a massive deficit, it should ignore Ireland and Greece and pay close attention to the U.K., with its independent currency and its well-thought-out fiscal plan.
If the U.K. can’t revive its flagging economy, the lesson won’t be that consolidation doesn’t work. It will be that targets based on the IMF data understated the importance of spending cuts -- and that highly indebted nations do so at their own peril.
(Kevin Hassett, director of economic-policy studies at the American Enterprise Institute, is a Bloomberg News columnist. He was an adviser to Republican Senator John McCain in the 2008 presidential election. The opinions expressed are his own.)
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