Alberto Alesina is a new favorite of fiscal hawks like former President George W. Bush's chief economic adviser, N. Gregory Mankiw. A professor of economics at Harvard University, the 53-year-old Italian disputes the need for more government spending to prop up growth and advocates spending cuts instead.
This is Alesina's hour. In April in Madrid, he told the European Union's economic and finance ministers that "large, credible, and decisive" spending cuts to reduce budget deficits have frequently been followed by economic growth. He backed his proposal with historical research on rich countries' experiences since 1980. Later, at the Group of 20 summit in Toronto on June 26-27, the presidents and prime ministers of the advanced economies agreed to shrink their budget gaps by half or more by 2013. That put pressure on President Barack Obama to follow the lead of cost-cutters such as Britain's Chancellor of the Exchequer, George Osborne, and German Chancellor Angela Merkel. Says Alesina: "I think the Germans are right."
Alesina argues that austerity can stimulate economic growth by calming bond markets, which lowers interest rates and promotes investment. In addition, he says, deficit-cutting reassures taxpayers that more wrenching fiscal adjustments won't be needed later. That revives their animal spirits and their spending. Alesina says that as a way to shrink deficits, spending cuts are better for growth than raising taxes. The Madrid paper, a summary of his views, was influential enough to be cited in the official communiqué of the EU finance ministers' meeting.
The U.S.'s Rare Situation
Alesina's historical research, though, doesn't shed much light on what might happen if the U.S. adopts an austerity budget, because current circumstances don't resemble most of those in Alesina's database. It's rare for a nation to suffer such a big shortfall in demand that it cuts interest rates to zero, as the U.S. has. It's even rarer for a government in such circumstances to tighten its fiscal belt. Japan's experience is a cautionary tale. Japan attempted to tackle its deficit in the late 1990s during a period of weak demand and near-zero rates. Many economists say the move prolonged the slump that became known as Japan's Lost Decade. To be sure, Japan tried to balance its budget mainly by raising taxes, which is not Alesina's preferred solution.
Economists who describe themselves as Keynesians or neo-Keynesians don't buy Alesina's medicine. Gauti B. Eggertsson, a staff economist at the Federal Reserve Bank of New York, concluded in a paper last November that, with interest rates at zero, the right remedy is to raise government spending, not cut it. Espousing his own views and not those of the Fed, Eggertsson wrote that when extremely loose monetary policy isn't stimulative enough, "the goal of policy should be to increase aggregate demand—the overall level of spending in the economy."
Alesina's own research shows mixed results from deficit-cutting. He identified 26 examples since 1980 of deficit reductions that triggered growth of gross domestic product and 21 that lowered government debt substantially. He found only nine double victories in which government policymakers managed both to expand their economies and reduce debt. (Among them: Ireland in 2000, and the Netherlands and Norway in 2006).
Alesina is unfazed. While acknowledging that experience with zero-rate situations is scant, he says, "I don't see how anyone can argue that we should push even more on the fiscal accelerator." He says the greatest risk to global growth is a financial crisis brought on by fears of government overindebtedness. Clearly, economists are as divided as politicians. The problem is that if austerity budgets are pursued and they prove ill-advised, many more people will suffer than just a few economists.
The bottom line Alesina has provided the theoretical ammunition fiscal conservatives want. The Keynesians say that his research does not apply.