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Things are looking up. Led by rising house prices, the US recovery is likely to accelerate this year. Budget deficit projections have declined, too. And although the European economy is stagnant, there is some evidence that stimulative policies are gaining traction in Japan. So this is an opportune moment to reconsider the principles that should guide fiscal policy.
A prudent government must balance spending and revenue collection in a way that assures the sustainability of its debts. To do otherwise would lead to instability and slow growth – and court default and catastrophe. Deficit financing of government activity is not a sustainable alternative to increasing revenues or to cutting public spending. It is only a means of deferring payment. Just as a household or business cannot indefinitely increase its debt relative to its income without becoming insolvent, the same holds for a government. There is no permanent option of public spending without raising commensurate revenue.
So it follows that there is, in normal times, no advantage to running large deficits. Public borrowing does not reduce ultimate tax burdens, and it tends to crowd-out borrowing by the private sector, which could otherwise finance growth. It encourages international borrowing, which means an excess of imports over exports. The private sector may also be discouraged from future spending if it fears that tax rises to pay for the deficit are on the horizon. That is why it is usually the job of the US Federal Reserve to manage demand in the economy by adjusting base interest rates, rather than the job of those in charge of deficit financing.
It was essentially this logic that drove the measures taken in the late 1980s and in the 1990s to balance the budget, usually on a bipartisan basis. As a consequence of policy steps taken in 1990, 1993 and 1997 it was possible – by the year 2000 – for the US Treasury to use surplus revenues to retire federal debt. Deficit reduction, the associated fall in capital costs and an increase in investment was an important contributor to the nation’s very strong economic performance during the 1990s when productivity growth soared and unemployment fell below 4 per cent. We enjoyed a virtuous circle in which reduced deficits led to lower capital costs and increased confidence, which led to more rapid growth, which further reduced deficits, reinforcing the cycle.
But responsible governing also requires recognising that when economies are weak and monetary policy is constrained, fiscal policy can have a large impact on economic activity. This can, in turn, improve revenue collections and reduce expenditure on social welfare. In such circumstances, attempts at rapid reductions in the budget deficit may backfire. That is where we have been in recent years. Circumstances have been anything but normal.
High unemployment, few job vacancies and deflationary pressures all indicate that output is not constrained by what the economy is capable of producing but by the level of demand. With base interest rates at or close to zero, the efficacy of monetary policy has been circumscribed. Under circumstances such as these, there is every reason to expect that changes in deficit policies will have direct impacts on employment and output in a way that is not normally the case. Borrowing to support spending – either by the government or the private sector – raises demand and therefore increases output and employment above the level they otherwise reach. Unlike in normal times, these gains will not be offset by reduced private spending because there is excess capacity in the economy. These so-called “multiplier effects” operate far more strongly during financial crisis economic downturns than in other times.
In a recent paper, J. Bradford DeLong, an economics professor at the University of California, Berkeley, and I estimated that contractionary fiscal policies might actually increase debt burdens because of their negative economic impacts. These estimates remain the subject of debate among other economists and policy should be driven by more than one study. But what follows from this analysis of the impact of fiscal policy?
First, the US and other countries will not benefit from further fiscal contraction directed at rapid deficit reduction. Not only will output and jobs suffer. A weaker economy means that our children may inherit an economy with more debt and less capacity to bear the burden it imposes. Already premature deficit reduction has taken a toll on economic performance in the UK and in several eurozone countries.
Second, while continued deficits are a necessary economic expedient, they are not a viable permanent strategy and measures that reduce future deficits can increase confidence. This could involve commitments to reduce spending or raise revenues. But there is an even better way. Pulling forward necessary future expenditures such as those to replenish military supplies, repair infrastructure, or rehabilitate government facilities both reduces future budget burdens and increases demand today.
This would be the right way to proceed – but getting there will require moving beyond political sloganeering for or against austerity, and focusing on what measures best support sustained economic growth.
The writer is Charles W. Eliot university professor at Harvard and a former US Treasury secretary