Pain in Spain May Bring No Economic Gain: News Analysis

So what can Spain do if it is stuck between a rock and a hard place—between the need to cut, which stifles growth, and the need to grow? New research by two economists on the question of austerity may provide an answer to this seeming paradox.

Alberto Alesina of Harvard and Francesco Giavazzi of Italy’s Bocconi University, in a paper published this week called The Austerity Question: ‘How’ is as Important as ‘How Much,’ argue that the way fiscal stability is achieved makes the critical difference. Specifically, they say “the accumulated evidence from over 40 years of fiscal adjustments across the OECD speaks loud and clear” that cutting spending has less of a recessionary impact than tax increases, and that spending cuts combined with easy money, labor-market and other structural reforms can stabilize if not reduce debt-to-GDP ratios.

Tax hikes aimed at increasing revenue do not succeed in arresting the rise in debt-to-GDP ratios, the authors say. “When these fiscal packages are announced entrepreneurs’ confidence falls sharply, and this is reflected in a fall in output.” This is all the more the case in the European context where tax revenues are close to 50% of GDP, they add. Moreover, spending cuts do not depress entrepreneurialism and often lead to an increase in GDP within a year, they say.

Indeed, the U.K. Treasury in February—in the first test of a new wealth tax introduced last year—received 509 million pounds less in revenue for the month of January compared with the previous year. The Treasury had projected that monthly revenues would actually increase by more than 1 billion pounds.

Alesina and Giavazzi criticize the new fiscal compact European leaders are expected to ratify soon. That agreement calls for fiscal austerity but ignores the critical question of the composition (i.e. how versus how much) of proposed fiscal packages.

Deficit reduction remains a key issue in this year’s U.S. presidential election as well, and the question of how deficit reduction is to be achieved will likely take a prominent place in the debate.