Fiscal Fibs and Follies

BERKELEY – Across the globe, the debate over fiscal consolidation has the distinct sound of two sides talking past one another.

On one side are those who insist that governments must move now, at all cost, to rein in budget deficits. Putting public finances on a sustainable footing, they argue, is essential to reassure financial markets. If concerted efforts are taken to balance budgets, confidence will be bolstered. And if confidence is bolstered, consumption and investment will rise.

In this view, cutting deficits will be expansionary. As evidence that this is not merely a hypothetical possibility, advocates of fiscal consolidation point to cases like Denmark in the early 1980’s, Ireland in the late 1980’s, and Finland in the 1990’s.

On the other side are those who insist that additional public spending is still needed to support demand. Private spending remains weak, not least where continued high unemployment has led consumers, concerned about future prospects, to pocket their wallets.

Moreover, the critics object, the evidence in support of expansionary fiscal consolidations is flawed. In each case where fiscal consolidation supposedly was expansionary, the economy grew because of some third factor. Denmark grew, despite fiscal cuts, because interest rates, initially in the double digits, came down. Ireland and Finland grew, despite fiscal cuts, because the exchange rate fell sharply, boosting exports.

The world economy today, desperate for demand, can’t count on either mechanism. Interest rates in many countries are already near zero. And all countries can’t depreciate their exchange rates at the same time.

So who is right? Consider the following image: consumers and investors as passengers in a car hurtling directly toward a brick wall. In this case, the driver stepping on the brake will give the passengers more confidence.

Here, the plausible passengers are southern European firms. They understand that their countries’ fiscal positions are unsustainable. They know that debt default would be disruptive. Seeing the economy hurtling toward a brick wall, they are holding their collective breath, while evidence that the government is serious about stepping on the brake can induce them to exhale. In this case, fiscal consolidation is likely to affect their investment spending positively.

This does not mean that Greece, Portugal, and Spain will expand as robustly as Denmark, Ireland, and Finland did in the 1980’s and 1990’s. They can’t lower the exchange rate to aid exports. But they can reduce interest rates by eliminating the perceived risk of sovereign default.  Banks will be able to borrow from one another for less, and thus able to lend to firms for less. This suggests that investment may respond better than the pessimists fear.

But what might work in southern Europe has no chance of working elsewhere. In other G-20 economies, including the United States, Germany, China, and Japan, the car is still cruising down an open road. Fiscal velocity may be considerable – that is, deficits may be large – but there is no sign of a brick wall ahead. Interest rates on government debt are still low. If the passengers were growing restive, they would rise. At this point, they have not.

In these countries, there is therefore no reason to think that fiscal consolidation would have a strong positive effect on confidence. That possibility could arise sometime in the future, when the proverbial brick wall comes into view. But it is not on the horizon yet, which means that there would be no positive private-spending response to buffer public-spending cuts. As a result, budget cuts would be strongly contractionary.

Finally there are borderline cases, like Britain. Chancellor of the Exchequer George Osborne insists that his country’s fiscal trajectory is dangerously unsustainable, and he has proposed draconian cuts. Others strongly disagree, noting the continued low level of interest rates, and that even under the previous government’s plan, net borrowing costs were already scheduled to fall by nearly two-thirds between 2010-11 and 2014-15.

It is almost as if governments like Britain’s are attempting to manipulate the private sector into believing that the dire conditions required for an expansionary fiscal consolidation have already been met. It as if they are trying to terrorize the private sector, so that when the fiscal ax actually falls, consumers and investors will be sufficiently relieved that disaster has been averted that they will increase spending.

If so, leaders are playing a dangerous game that depends on encouraging more future spending by exciting consumers and investors now, while depressing actual spending just when it is most urgently needed.

Or maybe politicians don’t believe any of this and are simply intent on cutting spending for ideological reasons, irrespective of the economic consequences. But who would be so cynical as to believe that?