August 19, 2022

Economix: Fiscal Contraction Hurts Growth

Today's Economist

Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

The United States has a large budget deficit and a ratio of debt to gross domestic product that, in most projections, continues to rise over time. Some House and Senate Republicans are arguing strongly that this situation calls for big, immediate cuts in government spending — for example, as part of any agreement to increase the federal government’s debt ceiling.

The Joint Economic Committee of Congress held a hearing on Tuesday to discuss whether such spending cuts would be contractionary or expansionary for the economy in the short run. After taking part as a witness at the hearing, I conclude that large immediate spending cuts would tend to slow the economy.

The general presumption is that fiscal contraction — cutting spending or raising taxes, or both — will immediately slow the economy relative to the growth it would have had otherwise. (Of course, some lawmakers and candidates call for cutting spending and cutting taxes, too. This would not lower the deficit, and, most likely, in the short term it would also lower growth, because the spending cuts will be more contractionary than the tax cuts are expansionary, in part for the reasons discussed below.)

But some studies have found that in particular instances, fiscal contractions — meaning deficit-reduction measures — have been consistent with no deceleration of economic growth. The International Monetary Fund produced the most balanced recent assessment of the available evidence in Chapter 3 of its October 2010 World Economic Outlook, “Will It Hurt? Macroeconomic Effects of Fiscal Consolidation.” (I was chief economist at the I.M.F. but left in August 2008 and had nothing to do with this study.)

Under four conditions, fiscal contractions can be expansionary. But none of these conditions is likely to apply in the United States today.

First, if there is high perceived sovereign default risk, fiscal contraction can potentially lower long-term interest rates. But the United States is currently among the countries with the lowest perceived risk — hence the widespread use of the dollar as a reserve asset.

To the extent there is pressure on long-term interest rates in the United States today because of fiscal concerns, these are mostly about the longer-term issues involving health care spending; if this spending were to be credibly constrained (e.g., in plausible projections for 2030 or 2050), long rates should fall.

In contrast, cutting discretionary spending, which is a relatively small part of the federal budget, would have little impact on the market assessment of our longer-term fiscal stability.

Second, it is highly unlikely that short-term spending cuts would directly increase confidence among households or companies, particularly with employment still around 5 percent below its precrisis level. The United States still has a significant “output gap” between actual and potential G.D.P., so unemployment is significantly above the achievable rate. Fiscal contractions rarely inspire confidence in such a situation.

Third, if monetary policy becomes more expansionary while fiscal policy contracts, this can offset to some degree the negative short-run effects of spending cuts on the economy. But in the United States today, short-term interest rates are as low as they can be and the Federal Reserve has already engaged in a substantial amount of “quantitative easing” to bring down interest rates on longer-term debt.

It is unclear that much more monetary policy expansion would be advisable, or possible, in the view of the Fed, even if unemployment increases again — as it might if fiscal contraction involves laying off government workers.

Fourth, tighter fiscal policy and easier monetary policy can, in small, open economies with flexible exchange rates, push down (that is, depreciate) the relative value of the currency — thus increasing exports and making it easier for domestic producers to compete against imports. But this is unlikely to happen in the United States, in part because other industrialized countries are also undertaking fiscal policy contraction.

Also, the pre-eminent reserve currency status of the dollar means that it rises and falls in response to world events outside our control — and at present political and economic instabilities elsewhere seem likely to keep the dollar relatively strong.

The available evidence, including international experience, suggests it is very unlikely that the United States could experience an “expansionary fiscal contraction” as a result of short-term cuts in discretionary domestic federal government spending.

The best way to bring the debt-to-G.D.P. ratio under control is to limit future spending increases and augment revenue while the economy continues to recover. In particular, health care spending needs to be credibly constrained but doing this properly would mean limiting health care costs as a percentage of G.D.P. — proposals that just push costs from government onto companies and individuals are not appealing.

There is also a pressing need for tax reform — to reduce complexity, lower distortions and, in particular, roll back the subsidies for household and corporate debt that have crept into the system. Excessive private sector debts pose a significant systemic and fiscal risk to the economy. The major reason government debt surged relative to G.D.P. in the last three years is the deep recession — the result of a financial crisis brought on by the irresponsible buildup of private debt.

Article source:

Speak Your Mind