November 11, 2010

Sickness to Health: How Drastic Budget Cuts Have Helped Countries Grow

David R. Henderson

Associate Professor of Economics, Naval Postgraduate School in Monterey

Alberto Alesina

Bruce Yandle

Distinguished Adjunct Fellow
Summary

If we learned anything from the mid-term elections, it’s that U.S. voters care more about results than rhetoric. Now, it’s time for Washington to do the same.

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This week President Obama’s deficit commission released its blueprint on how it proposes the U.S. should cut nearly $4 trillion in deficits over the next decade. The proposals, which include curbing increases in Social Security benefits, cutting defense spending, and eliminating billions in popular tax breaks for individuals and businesses, are causing some Congressional leaders to balk.

According to economists, however, the plan is on the right track. Reducing discretionary spending and eliminating earmarks may sound promising, but they only affect 12 percent of the budget, while Defense and entitlement spending account for 23 and 56 percent respectively, according to the Office of Management and Budget. Ignoring the long-term impact of these programs on the budget will ensure failure.

Unfortunately, most lawmakers consider cutting these types of programs to be political suicide. However, new research published by the Mercatus Center at George Mason University finds that not only have these types of cuts been hugely successful over a relatively short period of time, but many countries, including the U.S. have not suffered negative political backlash from them.

Two of these studies, authored by economist David R. Henderson of the Naval Postgraduate School, present a well-documented blue-print for how the United States can deal with its current economic situation by analyzing Canada’s debt reduction policies of the late 20th century and demobilization in the United States immediately following World War II.

In Canada, Finance Minister Paul Martin Jr. and Prime Minister Jean Chrétien, as members of the Liberty Party, were the unexpected champions of fiscal responsibility elected to office in 1993, said Henderson. They helped the Canadian government balance its budget and substantially reduce the national debt with large budget cuts—cuts in nominal dollars spent and only small increases in taxes.

“Chrétien and Martin’s efforts were so successful that in 2000 they reduced the corporate tax rate by seven percentage points,” said Henderson. “They cut income taxes, decreased the amount of capital gains subject to taxation, and increased the contribution limit for retirement accounts.”

Government spending didn’t just grow more slowly, it shrank, he said. They enforced discipline on other cabinet members; privatized government corporations like a railway, a uranium company, and the air traffic control system; and tightened Canada’s unemployment insurance program.

“In less than 15 years, Canada’s debt went from 68 percent of GDP in 1994 to 29 percent in 2008, and the economy boomed,” said Henderson. “As a result, Canada’s federal government ran a budget surplus every year between 1997 and 2008.”

Perhaps a more convincing example of how these types of policies can gain traction and success occurred in the United States following World War II. According to the Keynesian perspective, large post-war reductions in government purchases of goods and services would lead to a decline in aggregate demand and a decline in the economy’s real output.

“This coupled with a large increase in the number of unemployed people was a sure recipe for a recession,” said Henderson.

However, America defied this logic, and undertook the largest and fastest transition from a wartime economy to a peacetime economy with more success than any other country.

“Two good things happened to the U.S. economy when the war ended,” said Henderson. “Not only was there a huge reduction in government expenditures on goods and services that freed up resources for the private sector, but the United States moved from a relatively planned economy to a relatively free one by eliminating things like price controls.”

In the four years following the peak World War II in 1944, the U.S. government cut spending by 75 percent or $72 billion. Federal spending dropped 35 percent from 44 percent of gross national product in 1944 to only 8.9 percent in 1948. Although the unemployment rate, which was artificially low at the end of the war, did increase, from 1944 to 1948 the average unemployment rate was only 3.5 percent, he said.

According to Henderson, there are two reasons demobilization didn’t result in a recession: pent-up demand due to the heavy rationing and personal savings rates remained positive. The massive increase in private investment was key to meeting the demand during the postwar boom, because it led to private output in many forms: cars, refrigerators, washing machines, vacuum cleaners, and radios.

“In 1946, GDP increased by a stunning 29.5 percent,” said Henderson, “an all-time record for the U.S. economy.”

Contrary to popular belief, the post WWII boom was not an isolated event in U.S. history. The United States had a similar postwar boom after the Cold War when the first Bush and Clinton administrations helped cut the defense budget from 5.9 percent of GDP to 3.6 percent by 2000, says Henderson, while the Republicans constrained domestic spending following the 1994 elections. As a result, overall federal spending fell and real GDP grew by 40 percent from 1991 to 2000, he said.

Since the early 1990s, this story of large deficit reductions resulting in economic growth rather than a recession has played out in several countries, most frequently in Europe. When looking at the 10 OECD countries with the largest cumulative deficit reductions from 1975 to 2008, Harvard economist Alberto Alesina found not only were spending cuts much more effective than tax increases in stabilizing the debt and avoiding economic downturns, but they also did not affect the electoral success of the government, according to his recent paper published by the Mercatus Center.

The United States has already tried to spend its way into economic recovery to no avail and with arguably negative political consequences for those who supported the measures. The unemployment rate is still 9.6 percent and will likely break 10 percent even as the economy recovers due to disenchanted workers reentering the labor market, said Mercatus economist Bruce Yandle. It’s time for the U.S. to try something different.

“The U.S. may not yet be bankrupt, and there probably is time to adjust if the adjustments are begun immediately,” said Alesina. “However, simply ignoring the problem and continuing to rely on the discredited fiscal stimulus to push the economy along seems less and less like a sensible policy.”

If we learned anything from the mid-term elections, it’s that U.S. voters care more about results than rhetoric. Now, it’s time for Washington to do the same.