Sunday, July 04, 2010

The hot new economic buzzword...

As national debt concerns crowd out unemployment in the minds of some pundits (the employed ones, mostly), the idea of tackling the debt to increase the growth of the economy has become fashionable.  Since this idea strains the logic of how recessions work and recalls the blunder of 1937, proponents have come up with a new term to make it seem more plausible: fiscal consolidation.

Here's how to use it in a sentence:
Government spending in the current downturn may serve to prop up aggregate demand, which is crucial to stimulating economic recovery. However, governments need to be vigilant of future debt-servicing costs, especially as interest rates may be much higher in the future than those experienced over the last decade. Investors and the general public will expect a coherent and transparent commitment to controlling these financing costs through fiscal consolidation over the medium to long term. [More]
As near as I can tell, the meaning is to reduce deficits or at least deficit growth rates. But many of us find this new love affair with fiscal austerity to be very badly timed.

But proponents argue such cuts can be expansionary (growth-enhancing).
The brilliant thing is that this form of words covers those countries, such as Germany, who believe fiscal consolidation causes faster growth. It also covers others, who think that offsetting policies of lower business taxes or more flexible labour markets will foster growth even with fiscal contraction, forgetting that they could have the latter without the former. And even countries such as the US who prefer to keep a stimulus going can sign up to a medium-term ambition of growth-friendly fiscal consolidation. [More]
I suspect we may be about to repeat the effort of 1937 to control the short-term deficit at the expense of the long-term problem, while pushing us back into negative growth. It is simply too hard to convince enough voters that the counterintuitive need for government spending to promote growth and replace consumer cutbacks can be borne if we address structural deficits soon after a true expansion is underway.  This would include Medicare, first of all, but also defense, and other entitlements, such as ag programs.  Bruce Bartlett says it well.
A key point that every analysis has in common is that expansionary fiscal consolidation necessarily needs to concentrate almost entirely on the spending side to be successful; tax increases to reduce deficits are counterproductive. Highly respected Harvard economist Alberto Alesina is undoubtedly the strongest advocate of this view. In an April paper, he summarized more than 20 years of research on this topic. Alesina found that in many cases politicians implementing large fiscal adjustments even avoided a voter backlash.
I remain skeptical that immediate fiscal consolidation is desirable; I think the case for additional short-term stimulus is much stronger. (The necessity of long-term fiscal adjustment is unquestioned.) But if stimulus is effectively impossible, as I believe it is, we may have no choice but to test the theory that consolidation can be expansionary. I am inclined to think that there is a greater likelihood that we would be repeating the fiscal error of 1937, in which a sharp fiscal contraction brought on a recession, than that we will get the sort of results achieved in small countries starting with high inflation and interest rates. But if we go the consolidation route, we should at least try to concentrate as much of it as possible on the spending side of the budget, which is the one thing that every study says is essential for success. [More]
Meanwhile all this angst about deficits has not been reflected in the most obvious place  - the bond market.  More about what the heck is happening to comatose interest rates anon.

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