Fiscal Contraction Hurts Economic Expansion

The United States has a large budget deficit and a ratio of debt to gross domestic product that, in most projections, continues to rise over time. Some House and Senate Republicans are arguing strongly that this situation calls for big, immediate cuts in government spending — for example, as part of any agreement to increase the federal government’s debt ceiling .

The Joint Economic Committee of Congress held a hearing on Tuesday to discuss whether such spending cuts would be contractionary or expansionary for the economy in the short run. After taking part as a witness at the hearing, I conclude that large immediate spending cuts would tend to slow the economy.

The general presumption is that fiscal contraction — cutting spending or raising taxes, or both — will immediately slow the economy relative to the growth it would have had otherwise. (Of course, some lawmakers and candidates call for cutting spending and cutting taxes, too. This would not lower the deficit, and, most likely, in the short term it would also lower growth, because the spending cuts will be more contractionary than the tax cuts are expansionary, in part for the reasons discussed below.)

But some studies have found that in particular instances, fiscal contractions — meaning deficit-reduction measures — have been consistent with no deceleration of economic growth. The International Monetary Fund produced the most balanced recent assessment of the available evidence in Chapter 3 of its October 2010 World Economic Outlook, “ Will It Hurt? Macroeconomic Effects of Fiscal Consolidation .” (I was chief economist at the I.M.F. but left in August 2008 and had nothing to do with this study.) Under four conditions, fiscal contractions can be expansionary. But none of these conditions is likely to apply in the United States today.

First, if there is high perceived sovereign default risk , fiscal contraction can potentially lower long-term interest rates. But the United States is currently among the countries with the lowest perceived risk — hence the widespread use of the dollar as a reserve asset.

To the extent there is pressure on long-term interest rates in the United States today because of fiscal concerns, these are mostly about the longer-term issues involving health care spending; if this spending were to be credibly constrained (e.g., in plausible projections for 2030 or 2050), long rates should fall.

And Policymakers Are Proposing to Withdraw Stimulus? | www.bullfax.com

And Economic Outlook (January 2011), NBER, and author’s calculations.

Finally, on the spending side, government expenditures on goods and services are a negative component of overall GDP growth, in an accounting sense.

Figure 3: Real GDP growth 2011Q1 2nd release (blue bars), contributions from state and local government spending (red bar), and Federal spending (green bar), all in billions of Ch.2005$, SAAR. NBER defined recession dates shaded gray. Vertical line at 2009Q1. Source: BEA, 2011Q1 2nd release, NBER, and author’s calculations.

This figure reminds us that the Federal stimulus was largely offsetting contraction from the state and local governments. This point was highlighted in Aizenman and Pasricha 's analysis of spending (on both goods and transfers).

So, I think I understand where PIMCO’s Bill Gross is coming from ( The Hill ):

Bill Gross, the head of PIMCO, the world’s largest bond investor, on Tuesday lambasted politicians who claim deficit reduction will lead to job growth and called for new stimulus spending.

Gross is often cited by House Budget Committee Chairman Paul Ryan (R-Wis.) as having said the U.S. had only a few years to rein in the deficit to avoid a debt crisis. Gross sparked a lot of attention by dumping his holdings of U.S. Treasuries this spring.

“Deficits are important, but their immediate reduction can wait for a stronger economy ...

And from Fed Chair Ben Bernanke’s press conference yesterday (h/t Ezra Klein ):

I have advocated that the negotiations about the budget focus on the longer term, say 10 years, which is the budget window, or even longer if you're taking into blth entitlement reform, for example. By taking a long run aspect we can help the economy by reducing interest rates that may rise suddenly, we may help increase confidence in the households and businesses so ink it's desirable that we take strong action to lower our budget deficits over the longer term. In doing that I think it would be best not to, in light of the weakness of the recovery, it would be best not to have sudden and sharp fiscal consolidation in the near term.

That doesn't do so much for the long-run budget situation, it's a negative for growth ... . I hope that the congressional negotiators will take a longer-term view.

I don't think that sharp, immediate cuts in the deficit would create more jobs. I think in the short run that we're seeing already a certain amount of fiscal drag coming from state and local governments from the withdrawal of previous federal stimulus, so I think in the short run, you know, the fiscal tightening is at best neutral and probably somewhat negative for job creation.

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