Austerity or Stimulus?

Alberto Alesina, a Harvard economist, advises cutting deficits to revive growth in countries wishing to escape the Great Recession (Peter Coy, Businessweek, "Keynes vs. Alesina. Alesina Who?"). 

Alesina argues that austerity can stimulate economic growth by calming bond markets, which lowers interest rates and promotes investment. In addition, he says, deficit-cutting reassures taxpayers that more wrenching fiscal adjustments won't be needed later. That revives their animal spirits and their spending. Alesina says that as a way to shrink deficits, spending cuts are better for growth than raising taxes. The Madrid paper, a summary of his views, was influential enough to be cited in the official communiqué of the EU finance ministers' meeting...

Alesina's own research shows mixed results from deficit-cutting. He identified 26 examples since 1980 of deficit reductions that triggered growth of gross domestic product and 21 that lowered government debt substantially. He found only nine double victories in which government policymakers managed both to expand their economies and reduce debt. (Among them: Ireland in 2000, and the Netherlands and Norway in 2006).

Paul Krugman, a Princeton economist and a Nobel laureate who supports additional stimulus spending, argues condescendingly against supporters of austerity (New York Times, "Myths of Austerity").

This conventional wisdom isn’t based on either evidence or careful analysis. Instead, it rests on what we might charitably call sheer speculation, and less charitably call figments of the policy elite’s imagination — specifically, on belief in what I’ve come to think of as the invisible bond vigilante and the confidence fairy.

Bond vigilantes are investors who pull the plug on governments they perceive as unable or unwilling to pay their debts. Now there’s no question that countries can suffer crises of confidence (see Greece, debt of). But what the advocates of austerity claim is that (a) the bond vigilantes are about to attack America, and (b) spending anything more on stimulus will set them off.

Brad DeLong, a Berkeley economists, worries that leaders in Washington are not concerned about ten percent unemployment because they will not pass additional stimulus spending (The Week, "Does Washington care about unemployment?").

Still, where is the panic, the sense of urgency? The Obama administration and the Democratic majority in Congress passed a fiscal stimulus plan half the size recommended by Democratic economists fifteen months ago. Since then, they have been unable to assemble a political majority to finish the second half of the job. There seems to be no appetite for addressing ten percent unemployment.

How can they give such contradictory advise?  The empirical evidence does not overwhelmingly support either austerity or stimulus.  Multipliers, the fulcrum that magnifies the stimulus, are generally found to be small and to vary greatly depending on economic conditions including the state of the economy, a government's debt as a percentage of GDP, and the type of fiscal stimulus such as a tax cut or spending increase all affect the multiplier.  With so many variables, and so few observations, it is not surprising that empirical investigations produce mixed results.