More Economists in Favor of Smart Debt Reduction

A recent blog post by International Monetary Fund (IMF) economists Carlo Cottarelli and Philip Gerson on the IMF Direct blog highlights the importance of how deficit reduction plans are designed. Like many of the economists in our post last week, they make the case for a well-designed deficit reduction plan for the federal government to solve its fiscal problems.

Cottarelli and Gerson note the strong performance of many advanced economies in reducing government deficits in 2012. However, there is still a great deal of work to be done: several major economies have not posted strong enough deficit reduction numbers, including the United States:

But there is another group of countries—which unfortunately contains some of the very largest economies—where debt ratios are continuing to rise rapidly or have stabilized but at very elevated levels. Many of these countries will need to undertake significant deficit reduction in the coming years to return debt ratios to more sustainable levels, and even those countries where debt ratios have stabilized or started falling will need to commit to keeping their fiscal positions strong for many years to return public debt to safer levels.

In some countries, a few other resolutions would also be in order. The United States and Japan need to resolve to adopt and begin enacting credible medium-term plans to get their public finances back in shape. The short-term fiscal stimulus recently introduced by the Japanese authorities makes it even more imperative to tie down the longer term path for debt and deficits.

And while the United States has thankfully avoided the so-called fiscal cliff, it also needs to resolve to increase the debt ceiling expeditiously (and not just for a few months).

Cottarelli and Gerson emphasize that it is important how and when lawmakers reduce deficits. In the near term, lawmakers should protect the recovering economy and hold off changes but not indefinitely. An ideal plan would time most of the deficit reduction until after the economy has had more time to recover, but with the tremendous uncertainty surrounding the nation's current fiscal situation, a plan should be enacted now even if measures are phased-in slowly.

The concerns about the impact of deficit reductions on growth are valid, but the effect will depend on the specific design of fiscal adjustment policies, as well as on their timing.

Under normal circumstances, when the government cuts spending by $1, output normally falls by less than that because some of the resources that used to be employed to produce goods and services for the public sector will be freed up to produce for the private sector, instead.

But with a weak private sector, cuts in government spending are not partially offset by higher spending by households and firms. And with interest rates in many advanced economies close to zero, there is little scope for central banks to limit the impact of fiscal tightening by loosening monetary policy. That’s why governments that can afford to move gradually need to be careful not to tighten policy too much now.

But the current weak conditions will not last forever. As private sector balance sheets are mended and banks recover their lending capacity, private demand should pick up. When this happens, lower government demand for goods and services will be replaced in part by stronger private demand. Of course, this will require that monetary conditions remain relaxed for a long time. This is what the Fed has recently reiterated and what other central banks should do.

This means that, when financing conditions allow, countries that need to tighten policy should resolve to reduce their fiscal deficits in a gradual and steady manner that avoids excessive front-loading, a position we have advocated for some time.

The emphasis should be on both “gradual” and “adjustment”: just postponing all adjustment to the future would hardly be credible. The need to avoid excessive front loading has been recognized in many countries that are currently implementing Fund-supported adjustment programs. For example, in response to slow growth fiscal targets have been revised in both Ireland and Portugal, allowing for a more gradual pace of consolidation than would have been possible if the original deficit targets had been maintained.

Lawmakers will need to agree upon a plan that puts debt on a downward path of GDP. But just as important as the overall sizeof the package is the pace and structure of the plan. To minimize harm, lawmakers should look for phased-in policies that will promote greater efficiency both economically and fiscally, making the case for a serious look at our tax code and entitlement programs.