Cutting Spending or Raising Taxes?

A significant battle has been waged along a single line: The money supply (and its cousin, debt). Should there be spending to expand the money supply or austerity to shrink the money supply. This battle is seen through two completely different cultural experiences: The Americans shrank the money supply in the thirties and exaggerated the Depression, the Europeans--i.e. Germans--raised the money supply in the thirties and hyperinflation resulted....and Hitler. The G20 in Pittsburgh several years ago was a remarkable discordant meeting of smiling and insincere politicians who, while preaching unity, completely disagreed, Europe voting for austerity, the Americans for stimulus. There is now a movement in the U.S. toward austerity.

What works?

A group led by economist Alberto Alesina analyzed the International Monetary Fund history of all the fiscal plans that 17 OECD governments enacted between 1978 and 2009, including the U.S., Canada and Japan. Together, these countries tried everything to grow their economies—raise spending, cut spending, raise taxes or cut them, in endless combinations. There were 200 separate subsets. They published their results in an August 2012 paper on "fiscal consolidations" for the National Bureau of Economic Research (The NBER is an American private nonprofit research organization for economic research. Both Krugman and Friedman have been members.). Their results? "Adjustments based upon spending cuts are much less costly in terms of output losses than tax-based ones. Spending-based adjustments"—that is, spending cuts—"have been associated with mild and short-lived recessions, in many cases with no recession at all. Tax-based adjustments"—tax increases—"have been associated with prolonged and deep recessions."

The debate over "failed austerity" (Krugman) is misleading because it emphasizes spending cuts but rarely mentions tax increases. "Austerity" plans, the Alesina studies suggest, fail to revive growth when they too heavily rely on raising taxes on income and capital—as across Europe and now in the U.S.

Spending and tax policies must be seen as separate monetary factors but rarely are. According to the study, spending cuts can positively affect economic growth and is the only historically reliable way to lower deficits and debt.

Substituting tax increases for spending cuts is a dangerous route.