There has been an intense debate among economists for the past year over whether we should provide additional fiscal stimulus to keep growth on track, offset higher taxes and spending cuts at the state and local level, and perhaps prevent a double-dip recession, or begin the process of fiscal consolidation. Now it appears the debate is over.
Further government stimulus is extremely unlikely and debate among economists is shifting to the question of whether deficit reduction will bring on a recession, as happened in 1937, or actually be expansionary.
The case for additional stimulus can be found in the daily economic reports and dismal performance of the stock market. Growth has clearly stalled and it’s hard to see what is going to get it back up to an acceptable level. Consumption normally drives growth, but that’s not going to rise much as long as unemployment remains high. Businesses are not going to increase investment as long as consumption remains flat. Net exports—exports minus imports—have limited growth potential. That leaves only government, which is hobbled by political paralysis at the federal level and is being pulled down by fiscal contraction at the state and local level.
JPMorgan Chase estimates that the withdrawal of last year’s stimulus will subtract 1.25 percent from the annual real GDP growth rate over the next six quarters. Nevertheless, the need to begin fiscal consolidation appears to have reached virtually a consensus level among international economic agencies. The latest G20 communiqué said that failure to implement consolidation “would undermine confidence and hamper growth.”
If additional fiscal stimulus is effectively off the table, then what about the potential for monetary stimulus? With the federal funds rate near zero and rates on Treasury securities at historical lows, it’s hard to see what more can be done to induce borrowing by businesses or households in terms of monetary policy. The Fed could perhaps be more aggressive about quantitative easing—just buy anything and essentially print money to pay for it, some economists argue. But the Fed’s balance sheet is already stuffed with vast quantities of unconventional assets it acquired in 2008 to stem a financial meltdown. It would very much like to sell those assets as soon as possible, but can’t because whenever the Fed sells anything it contracts the money supply.
Thus it appears that both monetary and fiscal policy are impotent—in practice if not necessarily in theory. At the same time, members of both parties in Congress are extremely uncomfortable with the size of current and projected budget deficits, with almost everyone fearing a Greece-like meltdown if we don’t get our fiscal house in order soon. So if it seems inevitable that fiscal consolidation is going to be the order of the day, what are the potential consequences? Is there a silver lining behind what appears to be a contractionary cloud?
The possibility that fiscal consolidation might be stimulative starts with a theory called Ricardian equivalence that was first formulated by Harvard economist Robert Barro in the 1970s. He argued that budget deficits are not stimulative, as standard economic theory posits, because people implicitly discount the higher taxes that will be necessary to pay off the additional debt and hence save more. Thus deficits essentially have the same macroeconomic effects as higher taxes; depressing spending rather than raising it.
Ricardian equivalence is a highly controversial theory, but does appear to work in practice even if it is counterintuitive. If we accept it, then it necessarily follows that deficit reduction would be like a tax cut and be expansionary, rather than contractionary as standard theory says.
In 1990, two European economists, Francesco Giavazzi and Marco Pagano, wrote a path-breaking article showing that fiscal contractions could be expansionary. They argued that this was possible because deficit reductions improved consumer and business confidence by reducing expectation of higher taxes. However, Giavazzi and Pagano also noted that the fiscal contractions that appear to have had this effect took place during periods of relatively high inflation and interest rates. Thus a key channel through which deficit reduction improved economic conditions was by reducing inflationary expectations and interest rates.
In other cases, there were special factors that permitted countries engaging in fiscal contraction to offset it. One popular example often cited by conservatives is Canada in the 1990s, which reduced its budget deficit from 5.6 percent of GDP to a small surplus over a five-year period and saw real GDP growth rise sharply. But as a June 18 report from JPMorgan Chase points out, Canadian monetary policy eased significantly in the process and the Canadian dollar was allowed to depreciate, strongly boosting exports to the U.S., which was then in the midst of the tech boom.
Thus it turns out that fiscal contraction isn’t really expansionary except under conditions that do not exist today, and only when complimented by policies the U.S. is not free to pursue. Inflation and interest rates are at historically low levels and are not going to fall much lower even if the deficit disappears. As noted earlier, the Fed has limited capacity for further easing, and we can’t really depreciate our currency because it floats, nor is there any country to which we could realistically raise our exports to any great extent. Moreover, just about every other country is trying desperately to increase their exports to stimulate growth and all can’t do so simultaneously.
After examining the various episodes in which fiscal contractions appeared to be expansionary, economist Paul Krugman concluded that in every case it involved “key elements that make it useless as a precedent for our current situation.”
Nevertheless, the proposition that fiscal contractions are expansionary has become widely accepted. An April study from Goldman Sachs argued emphatically in favor of it. The June issue of the European Central Bank’s Monthly Bulletin (pp. 83-85) contains a strong endorsement of the idea. And recent studies and reports from the Bank for International Settlements, International Monetary Fund, British Treasury, and Organization for Economic Cooperation and Development have been sympathetic to the notion.
A key point that every analysis has in common is that expansionary fiscal consolidation necessarily needs to concentrate almost entirely on the spending side to be successful; tax increases to reduce deficits are counterproductive. Highly respected Harvard economist Alberto Alesina is undoubtedly the strongest advocate of this view. In an April paper, he summarized more than 20 years of research on this topic. Alesina found that in many cases politicians implementing large fiscal adjustments even avoided a voter backlash.
I remain skeptical that immediate fiscal consolidation is desirable; I think the case for additional short-term stimulus is much stronger. (The necessity of long-term fiscal adjustment is unquestioned.) But if stimulus is effectively impossible, as I believe it is, we may have no choice but to test the theory that consolidation can be expansionary. I am inclined to think that there is a greater likelihood that we would be repeating the fiscal error of 1937, in which a sharp fiscal contraction brought on a recession, than that we will get the sort of results achieved in small countries starting with high inflation and interest rates. But if we go the consolidation route, we should at least try to concentrate as much of it as possible on the spending side of the budget, which is the one thing that every study says is essential for success.
Bruce Bartlett is an American historian and columnist who focuses on the intersection between politics and economics. He has written for Forbes Magazine and Creators Syndicate, and his work is informed by many years in government, including as a senior policy analyst in the Reagan White House. He is the author of seven books including the New York Times best-seller, Impostor: How George W. Bush Bankrupted America and Betrayed the Reagan Legacy (Doubleday, 2006)