Is Postponing Fiscal Austerity an Option?

Karthik Reddy

The recent financial crisis has brought upon a variety of policy responses from governments, many of which, like the United States and Germany, responded to the downturn by enacting fiscal stimulus, which, through spending increases or tax cuts, aimed to increase demand. The concern about cutting fiscal stimulus is not unreasonable, giving Keynesian concerns that withdrawn government spending will decrease aggregate demand in the economy, leaving a void that the private sector is unable to fill due to economic uncertainty, a reluctance to lend, and sticky wages and prices that do not permit wages to drop quickly. Supporters of continued or even expanded fiscal stimulus, such as Paul Krugman, argue that the long-term implications of such fiscal unrestraint are small when compared with the chronic imbalances in some countries, the United States included. Unfortunately, however, this view is misguided for a number of reasons. First, though attractive as the existence of such a magical tool as the Keynesian multiplier greater than one may be, it remains a logical and statistical improbability. Furthermore, despite the claims of some commentators that debtor nations need not worry about the implications of their spending, large economies such as the United States and United Kingdom are not wholly immune to the market forces that have threatened their smaller counterparts such as Ireland. Moreover, fiscal irresponsibility must be weighed against the possibility that another crisis occurs, and against generational justice.

The argument for implementing and extending fiscal stimulus hinges on the accuracy of Keynesian economic theory. Keynes posited that in a period of economic recession, wages and prices do not fall fast enough to restore employment and spending to pre-crisis levels. This prolonged period of adjustment would involve a reduction of consumer spending, reducing corporate business revenues and therefore expenditures and investments. Moreover, as wages and prices were to adjust gradually to new economic conditions, deflation would theoretically halt lending and existing debts would become more expensive in real terms, deepening the recession. Keynes suggested that government should involve itself in deficit spending, such as much of the fiscal stimulus enacted in recent years, in order to increase aggregate demand and push the economy to full employment in a situation in which the private sector would not otherwise be able to do so. Crowding out of investment and resources by government expenditure in such a scenario would not occur because the private sector would be able to marshal these resources by itself. Government spending would in this scenario come at very little cost, would spur private spending, and would improve expectations about future economic conditions.

Unfortunately, the existence of such a tool as wonderful as the Keynesian multiplier is doubtful. Robert Barro, for example, has done considerable research on the United States during World War II, the Korean War, and the Vietnam War, and arrived at an overall estimator of the Keynesian multiplier of 0.8. Furthermore, Barro points out that the deflationary aspects of economic recession, as well as the problems of sticky wages and prices, to the extent they exist, may be combated by an expansionary monetary policy. It is similarly incorrect to believe that fiscal expansion comes at little or no cost to such countries. Reinhart and Rogoff’s findings regarding debt, for example, find that high debt-to-GDP ratios tend to have a negative correlation with growth. However inapplicable Paul Krugman would like these general findings to be to the United States, which issues a world reserve currency, they are a topical reminder of the fact that investors can, and do, lose faith in currencies. This is even more relevant to smaller economies, such as the United Kingdom and Japan, who have of late run high debt-to-GDP levels relative to historical trends. Furthermore, it is important to remember that Keynes called for countercyclical fiscal policy, which few governments committed to prior to the financial crisis when growth was booming; fiscal stimulus occurred at a time when budgets were already overextended. This further endangers the tenability of further fiscal stimulus in even more stable nations such as the United States.

Contrary to the unconcerned reassurance that emanates from the left, there exists the real cost of today’s fiscal expansion to the taxpayers of tomorrow. Government debt in the United States and many other developed nations is at high historic levels, and the fiscal outlook is dire, a fact recognized by even Paul Krugman. Yet unlike Krugman, who asserts that the cost of stimulus is negligible, one need only glance at the breadth of the expansion compared with existing deficits to measure its enormity: the 2011 federal budget is expected to bring the federal debt to 90% of GDP by 2010, arriving at the level, determined by Carmen Reinhart and Kenneth Rogoff, that predisposes countries to currency crises. This compares with a debt-to-GDP level of 40% prior to the financial crisis. Fiscal stimulus, combined with lower tax revenues, have generated a sharp increase in the debt that is not negligible, as claimed by stimulus-proponents, and must be paid for by future generations. The tremendous public expenditure has resulted in no meaningful reduction in employment or production. It is possible that firms anticipated that government stimulus would be short-term, and failed to increase employment in response to increased spending, which would suit well with the existence of a “jobless” recovery despite productivity increases. A more permanent government stimulus, such as a long-term cut to the corporate tax, may have had a greater impact on productivity and job creation than the short-term government spending authorized by the Obama administration and other governments worldwide.

It is understandable that governments in a crisis would want to err on the side of action, even if such action may not have helped economic recovery. Yet today, after massive stimulus has had no visible effect on employment or production while generating massive deficits, it is time to restore fiscal order to the developed world before markets begin to doubt the ability of major economies to repay the debts incurred over the past few years. Whatever short-run implications for growth by fiscal consolidation may be, the long-run benefits of monetary stability and investor and consumer confidence will benefit future generations much more than continuing a failed and expensive policy.