Earlier this week I had an opinion piece in The Canberra Times (a link is available here) quashing the notion that reductions in unproductive government expenditure will render significant harm to an economy.
The idea that spending cuts should be avoided from an economic standpoint is closely attuned with the Keynesian macroeconomic notion that reductions in expenditure by government will lead to a reduction in aggregate demand thus contributing to a fall in output and an adverse divergence away from a full?employment equilibrium state.
Of course, my Catallaxy colleague Steve Kates has already taught us many valuable lessons when it comes to the intellectual poverty of Keynesian ideas.
Without intending to steal Steve’s thunder of a classical economic repudiation of Keynesianism, my piece instead covers developments in modern macroeconomic theory which address a few key flaws in the Keynesian edifice: (i) the inclusion of a market for the supply and demand for money and credit; (ii) the inclusion of an external sector of the economy incorporating financial flows across national borders; and (iii) the role of expectations of the private sector in response to changing public sector policies.
All of these theories, which are taught in intermediate to advanced macroeconomic courses in most universities today, illustrate that the correspondences between private and public sector activities are far more complicated than what Keynes and his followers were able, or prepared, to acknowledge.
The developments in macroeconomics that I cited in the piece, and others that I didn’t have space to mention (such as the response of foreign investors to changes in fiscal stance), give rise, to some extent, to the possibility of an expansionary (rather than contractionary) economic response to fiscal consolidation.
The economists Alberto Alesina and Silvia Ardagna (see here) have cited a number of important case studies to support the theoretical contention that reductions in government expenditure as a way to restore sound fiscal order are more economically effective, at least in terms of recession avoidance, than fiscal consolidations based on tax increases.
One of the cases of fiscal consolidation studied by Alesina and Ardagna was the deficit reduction efforts of former Prime Minister Hawke and Treasurer Keating in the mid?1980s, that eventually led to the budget that brought ‘home the bacon’ as Keating exuberantly claimed.
As I explained in the opinion piece, they could well have included the Howard?Costello fiscal consolidation efforts in the late 1990s as part of their field evidence. The fiscal consolidation of former Prime Minister Howard and Treasurer Costello was largely (but granted not exclusively) focussed on expenditure cuts, including the application of a ‘yellow pages’ test for market outsourcing of administrative functions, a right?sizing of the Australian Public Service and reductions to a number of ineffectual labour market and industry policy programs.
The transition away from a commonwealth budget deficit contributed to some of the beneficial effects that assisted Australia during the 1998 Asian financial crisis, including an exchange rate depreciation and interest rate reductions. Apart from expected effects upon the public service citadel of Canberra, economic growth outcomes nationally weren’t adversely affected by the spending cuts, either.
Given the accumulation of theoretical explanations that contradict the Keynesian government spending cut gloomsaying, and the plentiful examples both at home and abroad of fiscal consolidations that freed up space for the efficient private sector to grow, it is a wonder why the government and its economic advisors were fervently in support of unnecessary fiscal stimulus in 2008?09 and so reticent to reduce expenditure even further today.