Slower Fiscal Contractions Are (Probably) Better

Slower Fiscal Contractions Are (Probably) Better
Some quick cuts, like limiting discretionary spending, are easy to make, but harder on growth
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Economists, like psychologists, are stuck with the unenviable task of proving with data things that the rest of us intuitively already suspect to be true. It makes intuitive sense, for example, that a sharp, immediate program of tax hikes and spending cuts would be more destructive than the same-size hikes and cuts drawn out over several years.

A new working paper by Steven Pennings of New York University and Esther Perez Ruiz of the International Monetary Fund puts some limited evidence behind this intuition. Fiscal policy prescriptions rely on “multipliers,” assumptions of how much effect a given dollar change in taxes or spending will have. Larger multipliers assume greater changes. The working paper looks at the multipliers of 63 “adjustment episodes”—political decisions to carry out tax hikes, spending cuts, or both—between 1978 and 2009 in the 17 economies of the Organization for Economic Cooperation and Development.

Pennings and Perez Ruiz developed measures of both the speed of a contraction and its evenness. Faster contractions are associated with higher multipliers, they found. And less even contractions, either front- or back-loaded, are associated with higher multipliers as well. The authors are careful to report a correlation, not causation; 63 episodes is a small sample set. (Though it’s about as big of a sample as you’re likely to find in a macroeconomic investigation.) They conclude, cautiously:

The paper hazards a few guesses at what might make a quick contraction harder on the economy. Longer contractions can spread out the pain over an entire business cycle, and there is some evidence that tightening fiscal policy during a recession causes higher multipliers. And some quick cuts, like limiting discretionary spending, are easy to make, but harder on growth. “For example,” the authors write, “pension reforms typically take long to negotiate and implement, but may have a lower impact on growth than, say, cutting back on public investment.”

Left unsaid was that this is exactly what has happened in the U.S. Over the long term, some kind of fiscal contraction will have to happen. But Congress cannot reach agreement on tax reform or medical spending, so instead it’s cutting the discretionary spending that is definitely not part of the long-term problem.

But here’s another unenviable part of being an economist: Just because empirical evidence shows something to be probably true doesn’t mean it’s politically possible. Pennings and Perez Ruiz recognize this:

Big changes require trust over time, the ability for two parties to say to each other, “Not only will we take this small step together now, we will take it again next year, and the year after that.” That trust is missing between parties in the U.S., and it is missing between countries in the euro zone; stronger countries fear that they can only force policy changes on weaker countries while a bailout program is still in place. So instead of paced, drawn-out contractions, we’re left with all that’s politically feasible: short, sharp, and probably more destructive cuts.

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