How Fiscal Austerity Can Boost Growth

Via Kevin Hassett, I see this interesting paper by Alberto Alesina, who argue that fiscal austerity can actually be expansionary on both theoretical and empirical grounds.

Alesina mentions three ways (there is actually a fourth way too in the form of a reduced trade deficit) by which the apparent demand reduction caused by fiscal austerity can be nullified. First of all, to the extent that there isn't Ricardian equivalence, interest rates will be reduced. And secondly, to the extent there is Ricardian equivalence, households and firms will be more willing to spend whatever income they still have. And thirdly, spending cuts such as reduced unemployment benefits and other means tested benefits boost supply, this will boost growth. However, tax increases that reduce supply, such as higher marginal income tax rates, will have a negative effect on growth.

Alesina then empirically test 107 cases of fiscal austerity and finds that they can be associated with both lower and higher relative growth after its implementation, The most striking result is that deficit reduction primarily based on lower government spending was usually expansionary, while deficit reduction primarily based on higher taxes was usually contractionary. This is exactly what could have been could be expected given the third theoretical point mentioned in the previous paragraph.