- Oct 26, 2006
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Europe is in the midst of a fiscal crisis caused by too much government spending, yet many of the continents politicians want the European Central Bank to purchase the dodgy debt of reckless welfare states such as Spain, Italy, Greece, and Portugal in order to prop up these big government policies.
So its especially noteworthy that economists at the European Central Bank have just produced a study showing that government spending is unambiguously harmful to economic performance. Here is a brief description of the key findings.
we analyse a wide set of 108 countries composed of both developed and emerging and developing countries, using a long time span running from 1970-2008, and employing different proxies for government size Our results show a significant negative effect of the size of government on growth. Interestingly, government consumption is consistently detrimental to output growth irrespective of the country sample considered (OECD, emerging and developing countries).
There are two very interesting takeaways from this new research. First, the evidence shows that the problem is government spending, and that problem exists regardless of whether the budget is financed by taxes or borrowing. Unfortunately, too many supposedly conservative policy makers fail to grasp this key distinction and mistakenly focus on the symptom (deficits) rather than the underlying disease (big government).
European Central Bank Research Shows that Government Spending Undermines Economic Performance « International Liberty
Overwhelming Evidence for Less Government Spending « International LibertyPoliticians argue for increased stimulus spending, as opposed to spending cuts, on the grounds that it would speed up economic recovery. This argument might have it exactly backward. Indeed, history shows that cutting spending in order to reduce deficits may be the key to promoting economic recovery. recent stimulus packages have proven that the multiplierthe effect on GDP per one dollar of increased government spendingis small. Stimulus spending also means that tax increases are coming in the future; such increases will further threaten economic growth. Economic history shows that even large adjustments in fiscal policy, if based on well-targeted spending cuts, have often led to expansions, not recessions. Fiscal adjustments based on higher taxes, on the other hand, have generally been recessionary. My colleague Silvia Ardagna and I recently co-authored a paper examining this pattern, as have many studies over the past 20 years. Our paper looks at the 107 large fiscal adjustmentsdefined as a cyclically adjusted deficit reduction of at least 1.5% in one yearthat took place in 21 Organization for Economic Cooperation and Development (OECD) countries between 1970 and 2007. Our results were striking: Over nearly 40 years, expansionary adjustments were based mostly on spending cuts, while recessionary adjustments were based mostly on tax increases. In the same paper we also examined years of large fiscal expansions, defined as increases in the cyclically adjusted deficit by at least 1.5% of GDP. Over 91 such cases, we found that tax cuts were much more expansionary than spending increases. How can spending cuts be expansionary? First, they signal that tax increases will not occur in the future, or that if they do they will be smaller. A credible plan to reduce government outlays significantly changes expectations of future tax liabilities. This, in turn, shifts peoples behavior. Consumers and especially investors are more willing to spend if they expect that spending and taxes will remain limited over a sustained period of time. On the other hand, fiscal adjustments based on tax increases reduce consumers disposable income and reduce incentives for productivity. Europe seems to have learned the lessons of the past decades: In fact, all the countries currently adjusting their fiscal policy are focusing on spending cuts, not tax hikes. Yet fiscal policy in the U.S. will sooner or later imply higher taxes if spending is not soon reduced. The evidence from the last 40 years suggests that spending increases meant to stimulate the economy and tax increases meant to reduce deficits are unlikely to achieve their goals. The opposite combination might.
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