Threading the Fiscal Needle

Of course, if many of the world’s economies attempt to consolidate simultaneously, with interest rates already low and some of the largest in a monetary union, such a favorable result is less likely. But the evidence on whether additional deficit-financed spending would quickly revive economic growth is mixed.

In a recent survey, , I concluded that short-run multipliers – the total change in economic activity resulting from higher government spending – could theoretically be as large as two when the central bank has reduced its target interest rate to zero. In other words, one dollar spent by the government could boost GDP by two dollars in the very short run.

The catch is that the multiplier turns negative by year two: extra government spending contracts, rather than expands, medium-term and long-term economic growth. Moreover, the short-run effect is lower in highly indebted countries, and can even be negative during economic expansions if households and firms, expecting higher taxes to pay for future spending, save, rather than spend, the cash.

Postponing fiscal consolidation risks aborting it, but consolidating too aggressively risks temporarily hindering growth. But those now demanding further deficit-financed stimulus must confront considerable evidence that an overhang of public debt impedes growth for a long time. In a following up on their book This Time is Different, the economists Carmen Reinhart and concluded that debt/GDP ratios above 90% tend to be associated with an annual growth slowdown of a full percentage point for 23 years. Thus, a debt overhang cumulatively costs more in lost income than a deep recession does.

Wise policy simultaneously considers short-, medium-, and long-term effects. Both Europe and the US badly need long-run reforms, for example, of public pensions and health care. Europe requires structural labor-market reform and must resolve its sovereign-debt overhang, banking crises, and the euro’s future. America must reform its tax code to raise revenue across a wider array of people and economic activity (half the US population pays no federal income tax, and the tax code either excludes or favorably treats many income sources).

Over the next several years – the medium term – all countries should implement difficult-to-reverse fiscal consolidation, which would persuade the private sector that a gradual or delayed adjustment, primarily on the spending side of the budget, will occur. Successful consolidation generally relies on spending cuts rather than tax increases – indeed, at a ratio of five or six to one. The US in the 1980’s and 1990’s reduced spending by 5% of GDP and balanced its budget while growing strongly. Canada, in the past two decades, has decreased spending by 8% of GDP and similarly prospered.

In the short run, spending flexibility is appropriate only if medium- and long-term measures are in place. That compromise – between Germany and Southern Europe, and between US Republicans and Democrats – should be economically and politically feasible.

With many citizens now struggling, political leaders face a daunting task: adopt credible medium- and long-term reforms without derailing the economy in the short term. They have little economic – and perhaps even less political – margin for error.

Michael Boskin, Chairman of George H.W. Bush’s Council of Economic Advisers from 1989-93, is Professor of Economics at Stanford University and Senior Fellow at the Hoover Institution.

Copyright: Project Syndicate, 2012.www.project-syndicate.org

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