The Case Against Both Paul Krugman and MMT

(Bloomberg Opinion) -- Austerity isn’t exactly the flavor du jour in international macroeconomics. The debate over a government’s tax-and-spending plans has lurched leftward, around the so-called “Modern Monetary Theory.” MMT argues that budget deficits don’t matter that much so long as states can print money. The only constraint is inflation, and this risk is often grossly exaggerated.

Such is the magnitude of the shift that Paul Krugman, the Nobel prize-winning economist who has lambasted austerity zealots throughout the financial crisis, is now defending orthodox macro (including the notion that deficits matter more than MMT fans claim) against attacks from the likes of Stephanie Kelton, a professor at Stony Brook University and Bloomberg Opinion columnist.

Some on the right will no doubt enjoy the spectacle of leftist academics at loggerheads, seeing in it a form of “contrapasso.” That’s the punishment in hell imagined by Dante, where sinners (in this case Krugman) have to suffer similar – but maybe even worse – torments to the ones they inflicted on the world. MMT is like Krugman’s more reasonable Keynesian theories on anabolic steroids.

The trouble with both Krugman and Kelton is that they ignore history. Time and again, governments have had little choice but to cut spending and increase taxes to reduce the deficit and stabilize the debt. Most economists would agree this should happen in the good times, when gross domestic product is growing fast and inflation is a risk. But politicians have failed repeatedly to make the most of a boom to put the public finances in order. As a result, they (or their successors) are often forced into belt-tightening at the wrong time, when the economy is shrinking and investors in sovereign bonds are on the run.

When this next happens, governments could do worse than pick up a copy of “Austerity,” a contrarian book written by Alberto Alesina, an economist at Harvard University, and Bocconi University’s Carlo Favero and Francesco Giavazzi. It’s an impressive study of nearly 200 episodes of fiscal consolidation in the rich world to understand what’s the best way to go about it. The answer – cutting spending is better than raising taxes – isn’t entirely new, but the supporting evidence is compelling and it will take an equally deep study to make the opposite case.

The three economists assemble a data-set of austerity plans carried out between the late 1970s and 2014 in 16 OECD economies, which is larger than any other similar work. They also look at the impact of fiscal plans over their duration, rather than analyzing changes within a single year. That’s a much better approach to this question. Governments often unveil multi-year austerity programs, which distribute cuts and tax hikes over time.

Nations have a choice when they want to achieve a certain level of savings: Increase taxes or cut spending. The book’s key finding is that when an austerity plan relies too much on higher levies it is often self-defeating. Growth typically plummets for several years, and the national debt doesn’t stabilize. Conversely, governments that prefer to cut spending are rewarded with a shorter slowdown and stronger finances.

This runs opposite to Keynesian economics, which argues that spending cuts are more contractionary than tax hikes because all of the money a government disburses ends up in economic activity, while consumers don’t always spend all of their income.

The three Austerity authors believe other factors are more important. When a government raises taxes, they write, individuals and corporates don’t expect these increases to be reversed and actually fear that they may get worse. That depresses economic activity, since people may decide to produce and consume less. Conversely, when politicians reduce public spending, corporations and consumers believe it may lead to tax cuts. That makes them more optimistic.

The book isn’t a manifesto for austerity every time and everywhere. The research doesn’t prove that the timing of an austerity program is irrelevant. That’s a question fought over by economists since the 2008 crisis, with the Keynesians arguing that states should always choose fiscal expansion when a crisis hits. The authors also acknowledge that some austerity plans have been pointless. In the case of Greece, restructuring the public debt much earlier would have delivered far better results than rounds of belt-tightening.

But the writers are correct to remind politicians that austerity needn’t be anathema; it’s a tool that can produce results if handled carefully. For example, governments can ax programs directed at the middle and upper class. Some spending also only exists because it is heavily defended by lobby groups or bureaucrats. Finally, cuts can help address inter-generational inequality, particularly when they target excessive pension benefits.

Once the MMT brouhaha is over, left-wing economists should take another look at austerity. The case for spending cuts may be wrong or overstated sometimes. But it takes more than wishful thinking to disprove it.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ferdinando Giugliano writes columns and editorials on European economics for Bloomberg Opinion. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times.

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