Hoover Daily Report

Larger Spending Cuts Would Help the Economy

via Wall Street Journal
Monday, March 4, 2013

President Obama's most recent prescription for economic growth—more government stimulus spending, new social programs, higher taxes on upper-income earners, subsidies for some industries and increased regulation for all of them—is likely to have the same anemic results as in his first administration.

Recall: The $825 billion stimulus program did little economic good at a cost of hundreds of thousands of dollars per job, even based on the administration's own inflated job estimates. Cash for Clunkers cost $3 billion merely to shift car sales forward a few months. The PPIP (Public-Private Investment Program for Legacy Assets) to buy toxic assets from the banks to speed lending generated just 3% of the $1 trillion that the program planners anticipated.

And now? Mr. Obama proposes universal preschool ($25 billion per year), "Fix it First" repairs to roads and bridges, plus an infrastructure bank ($50 billion), "Project Rebuild," refurbishing private properties in cities ($15 billion), endless green-energy subsidies, and a big hike in the minimum wage. The president and Senate Democrats also demand that half the spending cuts under sequestration be replaced with higher taxes.

These proposals are ill-considered. The evidence sadly suggests the initial improvement in children's cognitive skills from "Head Start" quickly evaporates. Higher minimum wages increase unemployment among low-skilled workers. A dozen recent studies in peer-reviewed journals, including one by the president's former chief economic adviser Christina Romer, document the negative effects of higher taxes on the economy.

As for adventures in industrial policy, former Obama economic adviser Larry Summers wrote a memo in 2009 about the impending $527 million loan guarantee to Solyndra and other recipients of government largess. "The government is a crappy v.c. [venture capitalist]," he wrote, in what is also the best postmortem. In 2010, Harvard economist Edward Glaeser concluded in the New York Times that infrastructure is poor stimulus because "It is impossible to spend quickly and wisely." Federal infrastructure spending should be dealt with in regular appropriations.

Will more spending today stimulate the economy? Standard Keynesian models that claim a quick boost from higher government spending show the effect quickly turns negative. So the spending needs to be repeated over and over, like a drug, to keep this hypothetical positive effect going. Japan tried that to little effect, starting in the 1990s. It now has the highest debt-to-GDP ratio among the countries of the Organization for Economic Cooperation and Development—and that debt is a prime cause, as well as effect, of Japan's enduring stagnation.

The United States is heading in this wrong direction. Even if the $110 billion in annual sequestration cuts are allowed to take place, the Congressional Budget Office projects that annual federal spending will increase by $2.4 trillion to $5.9 trillion in a decade. The higher debt implied by this spending will eventually crowd out investment, as holdings of government debt replace capital in private portfolios. Lower tangible capital formation means lower real wages in the future.

Since World War II, OECD countries that stabilized their budgets without recession averaged $5-$6 of actual spending cuts per dollar of tax hikes. Examples include the Netherlands in the mid-1990s and Sweden in the mid-2000s. In a paper last year for the Stanford Institute for Economic Policy Research, Stanford's John Cogan and John Taylor, with Volker Wieland and Maik Wolters of Frankfurt, Germany's Goethe University, show that a reduction in federal spending over several years amounting to 3% of GDP—bringing noninterest spending down to pre-financial-crisis levels—will increase short-term GDP.

Why? Because expectations of lower future taxes and debt, and therefore higher incomes, increase private spending. The U.S. reduced spending as a share of GDP by 5% from the mid-1980s to mid-1990s. Canada reduced its spending as share of GDP by 8% in the mid-'90s and 2000s. In both cases, the reductions reinforced a period of strong growth.

An economically "balanced" deficit-reduction program today would mean $5 of actual, not hypothetical, spending cuts per dollar of tax hikes. The fiscal-cliff deal reached on Jan. 1 instead was scored at $1 of spending cuts for every $40 of tax hikes.

Keynesian economists urge a delay on spending cuts on the grounds that they will hurt the struggling economy. Yet at just one-quarter of 1% of GDP this year, $43 billion of this year's sequester cuts in an economy with a GDP of more than $16 trillion is unlikely to be a major macroeconomic event.

Continued delay now leaves a long boom as the only time to control spending. There was some success in doing this in the mid-1990s under President Clinton and a Republican Congress. More commonly the opposite occurs: A boom brings a surge in tax revenues and politicians are anxious to spread the spending far and wide.

In any case, the demand by Mr. Obama and Senate Democrats that any dollar of spending cuts in budget agreements this spring (to fund the government for the rest of the fiscal year and when the debt limit again approaches) be matched by an additional dollar of tax hikes is economically unbalanced in the extreme. Those who are attempting to gradually slow the growth of federal spending while minimizing tax hikes have sound economics on their side.

Mr. Boskin, a professor of economics at Stanford University and senior fellow at the Hoover Institution, chaired the Council of Economic Advisers under President George H.W. Bush. This op-ed is based on the author's testimony last week before the U.S. Congress Joint Economic Committee.

Join the Conversation