Will immediate spending cuts in a vacuum result in immediate economic growth? Earlier, I argued that this belief conflicts with economic reality. In doing so, I mentioned that spending cuts now could cause economic growth now if they cause people to spend more now. I also said that there's a theory that says this could happen, which I rejected. Several commenters wrote in defense of this theory, which is basically Ricardian Equivalence. It says that consumers make current spending decisions based on their expected future tax obligation. I don't believe this theory holds in our real world today.
First, Ricardian equivalence makes a very shaky assumption: consumers are very, very rational. We aren't just talking about the consumer who exhibits basic rational behavior, like seeing two identical products with different prices and choosing the cheaper item. It requires a sort of hyper-rational consumer who has perfect foresight about the future and can predict how that future should shape his or her current budget. If such a consumer does exist, then he or she will revise current spending based on future tax obligation. I sincerely doubt this describes most Americans, if it describes any.
Don't get me wrong: there are situations you can imagine where some sorts of knowledge of future tax changes could cause changes in current expenditures, but they would have to be pretty aggressive changes which consumers are quite certain about. For example, perhaps a constitutional amendment passes saying that a value-added tax will go into effect on January 1, 2015 that will impose a 10% federal tax on all goods and services purchased. In that case, Ricardian equivalence may rightly dictate that consumers will cut their spending to prepare for the new tax.
But now let's try to apply the theory to our current debt situation and the idea that immediate spending cuts will result in immediate growth. Here's how the logic would have to go:
First, let's imagine an example of some super-aggressive debt cutting. If we were to first balance the budget (close the deficit) and then cut spending by $500 billion per year, the national debt will be paid off in just under 30 years. That would be incredibly aggressive cutting, more aggressive than any Congressional proposal out there.
How would consumers react? According to Ricardian equivalence, they would say, "Hooray! The government is cutting their spending, which means that -- once the debt is paid off -- my taxes might be lowered to match spending!" Presumably, taxes would be lowered by $500 billion per year about 30 years from now.
Even with this unrealistically optimistic picture of the U.S. managing to exercise incredible fiscal restraint, it is pretty inconceivable that consumers are thinking this way. Are they really going to spend more money now because in a few decades their taxes might decline? No one is so hyper-rational, whether rich, poor, or a chief financial officer of a Fortune 500 company.
In fact, the contemporary political environment makes Ricardian Equivalence even less likely to have any impact whatsoever. As just mentioned, the timeline for which we might see the debt paid down enough to result in lower taxes is extremely long. The political winds will sway in many directions throughout these decades. As a result, political uncertainty will be very high over this period. There is almost no certainty that whatever path government spending is put on today will be even remotely near where it is a few decades from now. Almost all congressmen who promise spending cuts now will be out of office in thirty years, and they will be responding to different economic challenges. In short, trying to make current spending decisions based on future tax obligation (according to current political precedent) is a fool's errand.
Just to be clear, as stated in the earlier post on this topic, there is a legitimate argument that less spending can lead to growth -- if it results in lower taxes. But that will only happen when the U.S. has its fiscal house in good order. That won't be any time soon.
However, as consumers and businesses become more certain that the debt is really shrinking and that the political discourse is one that broadly supports lower tax burdens, they may begin to revise spending through a reasonable assumption that future taxes will be lower. But the day when such an analysis will be rational is not today, 2012, or 2013. That day might not even come this decade.