Will Fiscal Austerity Help the Economy?

 | Sep 13, 2013 | 4:00 PM EDT
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The debate on the debt ceiling is approaching. As a condition for increasing the government's borrowing limit, congressional Republicans will likely argue for government spending cuts, and the Obama administration will argue against such fiscal consolidation.

If you side with the Republican argument, you might argue that stronger economic growth in the future will come about by lower government deficits and debt. Or, according to the Democrats' viewpoint, stronger economic growth now needs help from continued government spending. Who is right?

The debate among economists is ongoing with no definitive answer in sight. But austerity may provide long-run benefits even if it is costly in the short run. Thus, whether you look at the short term vs. the long term, both sides could be correct.

The Richmond Fed recently published a paper titled, Is Fiscal Austerity Good for the Economy?, that looks at research from several sources to see whether spending cuts and/or tax increases help or hurt. The economists look at the distinction between long-term and short-term results, and also factors in any accommodation from central banks, including conditions when short-term rates are held near zero.

Let's begin by considering one important point: Deficit spending is only possible without the markets fearing default if the accumulated federal government debt levels are equal to or below the present value of expected future budget surpluses. Besides the Fed's bond purchases, one reason why our interest rates haven't soared is because investors, businesses and consumers expect the government to eventually be able to pay back our national debt. That means that people expect taxes to rise and/or spending to be cut at some point in the future.

While the research wasn't conclusive for long-term results, it did suggest that spending cutbacks would benefit the longer run economic growth potential of a country with persistent deficits. However, the answer to short-term economic growth is clearer: Spending cutbacks would likely crimp economic growth. That is due to the simple economic principle that government deficit spending adds to GDP.

For the longer run, different research reached differing conclusions. That is not to say that fiscal restraint is or is not required; eventually, governments must be able to pay back their debt by revenues that exceed expenses at some point. In this report, the researchers wanted to determine how getting to that point will affect economic growth.

Research has found that tax increases harm the economy more than spending cuts do. Spending cuts signal a government that will consume fewer resources through lower taxation at some point in the future. Thus, consumers -- and especially businesses -- may view spending cuts as a longer-term positive. Businesses may then have more confidence to expand, grow and hire.

So it would seem as though fiscal consolidation could benefit longer-term economic growth. There's a big caveat, though: When short-term interest rates are already at zero, those spending cuts hurt more, damaging economic output in the short term because central banks can't help with providing monetary stimulus to offset the fiscal drag. In a more "normal" interest rate environment, the Fed could help stimulate the economy by lowering interest rates to offset the drag from federal government spending cuts.

That's not possible now, of course. With interest rates already at zero, and the Fed likely to taper its quantitative easing program, and then end bond purchases (including $45 billion of Treasury securities every month), the Fed isn't going to help offset the fiscal contraction. Instead, the Fed's stimulus will decelerate. That means spending cuts may hurt more than they normally would.

Of course, the big unknown question is how much more confident businesses would be with a federal government that can demonstrate that lower budget deficits now will mean taxes that won't rise by much later. The debate is difficult to answer simply, as the research didn't definitively answer whether and when austerity is likely to be beneficial to economic growth. The researchers also noted that more economic growth resulting from fiscal restraint doesn't necessarily mean all people will be better off -- especially those who are dependent on safety net programs.

But I would say that more confidence in potentially lower future taxes could mean more business investment and expansion now. And while we can't know the outcome, I would argue in favor of carefully and thoughtfully cutting government spending without harming the disadvantaged. The problem is how.

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