Deficit Reduction Doesn't Need to Be Front-loaded
Regular readers of The Bottom Line are probably familiar with our goal of putting the debt on a downward path as a share of the economy over the long term. Much of the conversation on fiscal policy recently has centered around arguments against "austerity," but smart deficit reduction is different. By taking into consideration the short-term economic effects of deficit reduction, budgets may be able to achieve most of the necessary savings when the economy has recovered while providing relative stability and confidence in the future fiscal outlook.
IMF Chief Economist Oliver Blanchard and Daniel Leigh of the IMF's Research Department show in a VOX blog post that there are many different factors in play when determining the timing of a fiscal consolidation plan:
When fiscal multipliers are large, government spending cuts and tax hikes have a large adverse effect on output in the short run, and a small initial effect on the ratio of debt to GDP (Eyraud and Weber, 2013). Indeed, as GDP may initially decline by more than debt, it may lead to an initial increase in the debt-to-GDP ratio, something we have seen in a number of countries in this crisis. (All that is needed, for example, is a multiplier above 1 and the sum of the ratio of revenue-to-GDP and the debt-to-GDP ratio above 100 per cent).
Large multipliers do not necessarily affect the optimal timing of fiscal consolidation, however. If they remain just as large in the future, the adjustment will be as painful later. But, if they are larger now than later, this tilts the adjustment toward doing more later: Less pain now, less pain later. And there are at least three reasons to believe that multipliers are larger now.
A second argument in favour of backloading is that, when growth is low, the economy is more vulnerable to “stalling” and slipping into recession (Nailwaik, 2011, Sheets, 2011, and others). Tightening fiscal policy when growth is low is thus riskier than when growth is near normal. (A more accurate statement would probably replace “low growth” by “large output gap” as it is really the level of activity that matters here. But the literature has focused on growth rather than on the gap.)
In this sense, the large fiscal consolidation taking place in the United States this year is not as bad, given relatively strong private demand, as the same fiscal consolidation would be in countries where private demand is very weak.
A third argument in favor of backloading is that fiscal consolidation carries the risk of causing long-term economic damage through hysteresis effects. DeLong and Summers (2012) have argued that a process of “hysteresis” links the short-term cycle to the long-term trend, implying more persistent fiscal policy effects.
Just like large multipliers, however, hysteresis does not necessarily have implications for the timing of fiscal consolidation. The adjustment will be just as painful in the future as it is today. What is needed to tilt the desirable adjustment path is for hysteresis to be stronger today than in the future.
As in the case of multipliers, there are indeed good reasons to think that hysteresis is stronger now.
Note that none of these arguments support the idea that we should ignore the debt entirely; rather, they complement the notion of a fiscal consolidation package that should be phased in over time. Blanchard describes the two risks of high debt: a "debt overhang," or an extended period of high debt that may be difficult to get out of, and an increased risk of a fiscal crisis. The question before lawmakers is how to best reduce debt, in particular, how quickly deficit reduction should proceed to simultaneously protect the economy in the short term and reduce the risks of a debt overhang over the longer term.
So, how do countries get out of the danger zone? Even with a large and steady fiscal consolidation, decreasing the debt-to-GDP ratio from, say, 100 per cent to 60 per cent is a slow process, likely to take decades. So the bad news is: Debt will be high for a long time. There is, however, some good news as well: The evidence shows that markets, to assess risk, look at much more than just current debt and deficits. In a word, they care about credibility. The danger zone is not defined by a magic threshold for the debt-to-GDP ratio, but by a much more complex set of characteristics of the fiscal and economic situation.
How best to achieve credibility? A medium-term plan is clearly important. So are fiscal rules, and, where needed, retirement and public health care reforms which reduce the growth rate of spending over time. The question, in our context, is whether frontloading increases credibility.
If one measures credibility by the size of the sovereign spread, the econometric evidence from the crisis is ambiguous. Smaller deficits appear to reduce spreads, but lower growth increases them (Cottarelli and Jaramillo, 2012). Thus, whether or not faster fiscal consolidation decreases spreads depends on whether the effect of a smaller deficit dominates the effect of lower growth. This, in turn, depends on the size of fiscal multipliers. And, for a plausible range of multipliers, the answer can go either way.
To put it another way, it is unclear whether front-loaded deficit reduction is necessary to establish credibility and with the economy still recovering, front-loaded deficit reduction may be less effective by harming growth. While Blanchard argues that each case must be considered individually, a credible medium-term deficit reduction plan might be preferred.
In a Financial Times op-ed, Larry Summers takes a stronger stance against front-loaded deficit reduction, but cautions against forgetting about debt and deficits entirely:
On all but the most optimistic forecasts, further actions will be necessary almost everywhere in the industrial world to assure that debt levels are sustainable after economies recover.
This is not the time for austerity, but we forget at our peril that debt-financed spending is not an alternative to cutting other spending or raising taxes. It is only a way of deferring those painful acts.
Lawmakers need to get the timing right in order for deficit reduction to be most effective. Immediate austerity is the worst way to go about deficit reduction, and it is not representative of what a deficit reduction plan has to be. For example, the new Simpson-Bowles plan contains less deficit reduction in 2014 and 2015 than sequestration, while achieving greater ten-year deficit reduction. Policymakers should see the "why" on deficit reduction and turn their focus to the "how" and "when."