Could The US Have An “Expansionary Fiscal Contraction”?
By Simon Johnson
The US has a large budget deficit and a debt-to-GDP ratio that, in most projections, continues to rise over time. Some House and Senate Republicans are arguing strongly that this situation calls for large and immediate cuts to 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. My assessment, after participating as a witness at the hearing, is that large immediate spending cuts would tend to slow the economy (a webcast of the hearing is here).
The general presumption is that fiscal contraction – cutting spending and/or raising taxes – will immediately slow the economy relative to the growth path it would have had otherwise.
However, some studies have found that, in particular instances, fiscal contractions – meaning deficit reduction measures – have been consistent with no deceleration of economic growth. The IMF produced the most balanced recent assessment of the available evidence in Chapter 3 of its October 2010 World Economic Outlook, entitled, “Will It Hurt? Macroeconomic Effects of Fiscal Consolidation.” (I was previously chief economist at the IMF, but I left in August 2008 and had nothing to do with this study.)
There are four conditions under which fiscal contractions can be expansionary. But none of these conditions are 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 US is currently one the lowest perceived risk countries in the world – hence the widespread use of the US dollar as a reserve asset. To the extent there is pressure on long-term interest rates in the US today due to fiscal concerns, these are mostly about the longer-term issues involving healthcare 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 also highly unlikely that short-term spending cuts would directly boost confidence among households or firms in the current US situation, particularly with employment still around 5 percent below its pre-crisis level. The US still has a significant “output gap” between actual and potential GDP, 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 US 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 – for example because 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 (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 preeminent 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 debt-GDP under control is to limit future spending increases and boost 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 percent of GDP – proposals that just push costs from government onto firms 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 debt surged relative to GDP in the past three years is the deep recession – the result of a financial crisis brought on by the irresponsible build up of debt.
An edited version of this post appeared this morning on the NYT’s Economix blog; it is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.