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Talk about a killer case of cognitive dissonance among folks like Paul Krugman, Larry Summers, Robert Rubin, and Joseph Stiglitz.
Consider this situation: A national leader is faced with a huge debt problem and a slow-growth economy. After consulting with economic experts, he decides on a strategy of cutting spending and raising taxes. Not only will this reduce debt, but it will also — theoretically — reassure financial markets that his government is serious about anti-inflationary fiscal reform.
As a result, the leader hopes and prays, the “bond market vigilantes” will lower interest rates, boosting growth (offsetting the fiscal retrenchment) and further shrinking debt as a share of the economy.
Call it pro-growth austerity. Win-win.
This is more or less what’s happening throughout Europe. Britain’s David Cameron, for instance, has stated that the purpose of his austerity plan was “to deliver low interest rates which are essential for growth.”
If that sounds like a familiar economic formula, it’s because that was the essential rationale of President Clinton’s economic strategy in 1993. After consulting with Federal Reserve Chairman Alan Greenspan and liberal economist Alan Blinder, Clinton embraced what became known as the “bond market strategy.” Raise taxes (which meant Clinton dumped his campaign’s investment agenda), cut defense spending, and hope long-term interest rates fall.
It was this economic approach that prompted Clinton political adviser James Carville to remark, “I used to think if there was reincarnation, I wanted to come back as the president or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone.”
Indeed, liberals/Democrats/progressives often point to Clintonomics as the proper way economic policy should be run — and how tax increases don’t hurt economic growth. Yet these same people have been knocking Europe for following the same path.
While long-term rates fell from 7.4% at the start of 1993 to 5.8% in October 1993—Bill signed his tax hike law back in August of that year—they then headed back up, moving steadily higher until Nov. 7, 1994,when they peaked at 8.16%. That was almost a full point higher than before the “bond market strategy” was implemented.
But rates fell the next day, the day of the midterm election, when Republicans surprisingly took the U.S. House and Senate. That’s when rates really began the long descent that Clinton predicted. One explanation: The 1993 drop in rates happened because investors were expecting a recession. The 1994 drop may have been more indicative of market expectations that the new GOP Congress would really get tough on spending while also pursuing — and this is key — a pro-growth tax policy. Indeed, during the Bill Clinton-Newt Gingrich Era, investment taxes were cut, and spending dropped to its lowest level as a share of the economy since the 1950s.
But liberals, strangely, don’t much like the EU’s version of Clintonomics. They blame it for pushing the region back into recession. Actually, what they really blame is government spending cuts. They never seem to blame the massive tax increases. Spain, for instance, now has a 52% top marginal tax rate plus a 21% VAT. Four years ago it was 43% and 16%. That is the wrong kind of austerity. As one study put it:
It stands to reason that European countries where tax revenues are close to 50% of GDP do not have the room to increase revenues even more.
A paper by Harald Uhlig and Mathias Trabandt (2012) nicely shows how close many European countries are to the top of realistically measured Laffer curves. Thus, any additional tax hikes would lead to relative low increases in tax revenues and could be very recessionary, through the usual supply- and demand-side channels.
Unfortunately, a massive 40% of EU fiscal adjustment is from the tax side in high-tax Europe, a region already at the top of the Laffer Curve. (And that number was compiled before another round of EU tax hikes.) Successful fiscal consolidations in general are more like 80-20, not 60-40. Europe, given its giant tax burden, probably should have been all spending cuts.
Tax-hike austerity didn’t work for America in the 1990s, and it’s not working for Europe today. Unfortunately, we may be trying it again since the bulk of the oncoming, $6 trillion “fiscal cliff” — some 80% — is made up of higher taxes. Apparently, folks on the left only like tax-hike austerity when it is tried here.
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