Why Consolidate?

These considerations apply to the US and some European countries today. Together with poor design, they explain why America’s 2009 stimulus cost several hundred thousand dollars per temporary job created.

Recent research also reveals that in OECD countries since World War II, successful fiscal consolidation – defined as stabilizing the budget while avoiding recession – averaged $5-$6 of actual spending cuts per dollar of tax hikes. Cuts in spending, especially on entitlements and transfers, were far less likely to cause recessions than tax increases were. Unfortunately, tax hikes have predominated in many recent European consolidations, including last week’s proposed Cyprus bailout.

Of course, caution is appropriate in order to avoid claiming too much for the benefits of short-run consolidation. After all, the current American and European economies differ in important ways from the other post-war cases – size, simultaneous consolidation in many countries, already-low interest rates, and the dollar’s status as the main global reserve currency.

But, other than in deep recessions, the validity of the Keynesian claim that delaying spending cuts is necessary to avoid undermining the economy is at best unclear, and would leave a long boom as the only time to control spending. And large deficits and high debt levels decrease the prospects for a long boom. Moreover, credibly phasing in spending reductions as the economy recovers is no easy task, given the political economy of the budget and the inability of one legislature to bind the next.

Worse yet, the cost of delay and increased deficits and debt is enormous. For example, without major reform in the US entitlement programs – which are exploding in size as a result of rising real benefits per beneficiary and an aging population – the next generation can expect a 20% reduction in living standards.

The most credible reforms are structural – for example, higher retirement ages and changes to benefit formulas – and difficult to alter once they are implemented. Merely setting a dollar (or pound or euro) target for budget cuts is far less effective, because the target can easily be revised – and cuts reversed – to avoid political pain.

If there were some short-term stimulus that was timely and likely to raise output and employment at a reasonable long-term cost, I would be all for it. But the evidence is that highly effective fiscal policy, even at the zero lower bound on interest rates, remains at best a theoretical possibility, subject to severe political constraints. While consolidation may imply some short-term costs, especially in a recession, the long-term costs of delay are large. It would be best if a credible consolidation program could be phased in gradually; but consolidation needs to proceed nonetheless – and primarily by controlling spending.

Michael Boskin, Professor of Economics at Stanford University and Senior Fellow at the Hoover Institution, was Chairman of George H. W. Bush’s Council of Economic Advisers from 1989 to 1993.

Copyright: Project Syndicate, 2013.

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