No Time for Wrong Steps

Friday, October 26, 2012
Greek protesters
Image credit: 
Ierapatra2501/Creative Commons

Elections often turn on the state of the economy, especially in hard times. When growth and jobs are down, voters throw out incumbents—whether Spanish leftists, French rightists, or Dutch centrists. The United States is no exception.

Economic performance depends to a considerable extent on economic policy. The Great Depression was intensified by poor monetary policy, tax increases, and protectionism. Likewise, loose U.S. monetary policy in the middle of the past decade helped set the stage for the Great Recession.

The outcomes of two related policy battles hold the key to the economic and political outlook in both the United States and Europe. The first is between “austerity” and “growth”—that is, short-term deficit reduction and additional fiscal stimulus. The second involves long-run structural issues: slowing the growth of government spending, reforming taxes, and increasing labor-market flexibility.

Take the austerity battle first. Many people on the left, on both sides of the Atlantic, argue that more, not less, government spending is required to lift their economies out of recession. People on the right believe that governments’ top priority should be fiscal consolidation. In Europe, large deficits and exploding debt-to-GDP ratios have alarmed creditors and provoked political tension. In particular, Germany demands more fiscal belt-tightening from heavily indebted southern European countries, whose unions (and voters) reject further austerity. American political leaders confront the same problem of debt and fiscal sustainability, although the United States thus far has avoided the bond market’s wrath.

The struggle over structural issues also bridges the Atlantic. In Europe, raising the retirement age for public pensions and shrinking government employment would curtail welfare-state excesses. America once seemed content to stop well short of the European social-welfare model; voters sent this signal when they elected Ronald Reagan to the presidency in 1980. But the current president and his congressional allies have rejected the consensus that government should be only a last resort for those in need. President Obama and his allies favor greater dependence, for both individuals and firms, on entitlement programs and other public spending, targeted tax breaks, regulations, and loans.

Separating the budget’s effects on the economy from those of the economy on the budget is tricky. There are several cases—in Ireland and Denmark in the 1980s, for example—in which fiscal consolidation helped expand the economy in the short run, as lower interest and exchange rates boosted confidence enough to stimulate demand. Of course, if many of the world’s economies attempted to consolidate at the same time, with interest rates already low and some of the largest economies 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.

An overhang of public debt impedes growth for a long time. One study estimated 23 years.

In a recent survey, “Fiscal Policy for Economic Growth,” 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.

Greek protesters
Greek protesters in Ierapetra shackle themselves to a huge “bomb” symbolizing International Monetary Fund and European Union policies imposed on their troubled economy. The bomb is labeled “Memorandum,” for the Memorandum of Understanding agreed upon by Greek political leaders. The demonstrators feared the agreement would lead to the closure of a local hospital.

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.

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 recent paper following up on their book This Time Is Different, the economists Carmen Reinhart and Kenneth Rogoff concluded that debt/GDP ratios above 90 percent tend to be associated with an annual growth slowdown of a full percentage point for twenty-three 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 United States 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 U.S. population pays no federal income tax, and the tax code either excludes or favorably treats many income sources).

Both Europe and the United States badly need long-run reforms of public pensions and health care.

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. In the 1980s and 1990s the United States reduced spending by 5 percent of GDP and balanced its budget while growing strongly. Canada, in the past two decades, has decreased spending by 8 percent 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 Republicans and Democrats in the United States—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.