Memo for FY2011 Budget Preparation: Positive Effects from Preannouncing Deficit Reduction

Faced with massive debt burdens coming out of the economic and financial crisis – even before the retirement and health care tsunami hits – experts agree we need to get our fiscal house in order, ideally under our own steam - before changes are forced upon us by our creditors. Experts also agree that acting sooner rather than later will mean that the fiscal downsizing needed will be smaller and less painful. Is there anything we can do in the near future (like maybe next year’s budget round) without undercutting the recovery?

Surprisingly, the answer is yes. Agreeing now on credible deficit reduction steps to be taken in the future (when the economy is on stronger footing) can have an immediate positive effect on financial conditions and economic growth by influencing fiscal expectations.

Moreover, making credible plans soon could also boost the recovery through altering expectations of large fiscal deficits needed to be financed, as the economy returned to full employment over the next five years.

This advice was given during last weekend’s IMF meetings in Istanbul, by Angel Gurria, the head of the OECD (the Organization for Economic Cooperation and Development, the Paris-based government economic policy think tank whose members are the U.S. and other industrialized countries). The following is the relevant passage of Dr. Gurria’s statement:

“[I]t is critical that governments develop now a concrete, credible and comprehensive consolidation plan to bring government finances back into a sustainable footing, even if actual implementation will only commence later. Striking the right balance between care for a fragile recovery and the need for fiscal consolidation will be a challenge when preparing the 2011 budgets. Moreover, the size and the synchronization of the required fiscal adjustment are likely to make it more painful than in most previous episodes of consolidation.

Consolidation efforts should thus aim to be undertaken in a way that minimizes its impact on demand and on long term growth potential. In this regard, action now to decide the reforms of pension and health systems that are anyway required in a context of ageing and spending pressures can help to create confidence and thereby facilitate keeping long term interest rates low while not hurting near-demand prospects.”