Why Consolidate?

STANFORD – Around the world, raging debates about whether, when, how, and how much to reduce large budget deficits and high levels of sovereign debt are dividing policymakers and publics. Diametrically opposed spending, tax, monetary, and regulatory policies and proposals are proliferating. To consolidate (the budget), or not to consolidate, that is the question.

The political left clamors for more spending, higher taxes on high-income earners, and delayed fiscal consolidation. For example, the economist and New York Times columnist Paul Krugman proposes waiting 10-15 years. (Many of the same people argued for analogous reasons against the Federal Reserve’s successful disinflation policies in the early 1980’s.) The political right calls for more rapid deficit reduction by cutting spending.

In Europe, policymakers, including the European Central Bank, demand consolidation for high-debt countries, but are flexible in negotiations; voters, however, reject it – most recently in Italy. In the United States, Republicans propose to balance the budget within ten years by reforming entitlement spending and taxes (with fewer exemptions, deductions, and credits providing the revenue needed to reduce personal tax rates and a corporate rate that, at 35%, is the ).

America’s Senate Democrats propose $1.5 trillion in higher taxes over ten years (on top of the $600 billion agreed in early January), $100 billion (twice that, for House Democrats) in new stimulus spending, and modest longer-term expenditure cuts. Their version of tax reform would mean reducing deductions for the wealthy and corporations, with no rate reductions.

What are the likely costs and benefits of stimulus versus consolidation? And what is the best combination of spending cuts and tax hikes?

Economists agree that, at full employment, higher government spending crowds out private spending. Keynesian models claiming a quick boost from higher government spending below full employment show that the effect soon turns negative. So it needs to be repeated over and over, like a drug, to sustain the economic high. That strategy saddled Japan with the world’s highest debt/GDP ratio, to little benefit.

To be sure, recent research suggests that increased government spending can be effective in temporarily raising output and employment during deep, long-lasting recessions when the central bank has reduced its short-term policy interest rate to zero. But the same research suggests that the government spending multiplier is likely to be small or even negative in a variety of circumstances and, in any event, would quickly shrink.

Such circumstances include, first, a high debt/GDP ratio, with rising interest rates impeding growth. Likewise, during expansions, higher government spending is more likely to crowd out private spending. Spending on transfer payments and/or nonmilitary purchases – which can become entrenched or be procured more cheaply from abroad (for example, solar panels and wind turbines, respectively, in America’s 2009 fiscal stimulus) – is also likely to yield only a small multiplier. And, when the economy has flexible exchange rates, if government spending raises interest rates, the currency will strengthen, leading to a decrease in investment and net exports. Finally, the effects of additional government spending may be offset by people’s expectations of higher taxes once the central bank exits the zero lower bound on interest rates (causing them to spend less now).

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