Wednesday, July 14, 2010

The Two Sides Of The Argument For Fiscal Consolidation

One argument for government to reduce deficits is that it will give confidence to the markets and encourage spending and investment. The other side argues that public spending is needed to boost up consumer demand as the consequences of the piling debt still seem far out in the future. See the following post from Economist's View.

I feel like I've hammered this point to death, but I also feel that, despite the incessant pounding, the nail is still loose. Maybe the answer is a bigger hammer. Or a better nail. What's the equivalent of a "molly" when trying to make an argument stick?:
Fiscal Fibs and Follies, by Barry Eichengreen, Commentary, Project Syndicate: 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. ... And if confidence is bolstered, consumption and investment will rise. In this view, cutting deficits will be expansionary. ...

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. ...

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. ...

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... As a result, budget cuts would be strongly contractionary.

Finally there are borderline cases, like Britain. ... It is almost as if governments like Britain’s 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...

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?
A car going quite a bit slower than the speed limit on a clear, open road could also make passengers happier -- and increase confidence by reducing their assessment of the time it will take to reach the full employment, higher growth destination -- by speeding up.

This post has been republished from Mark Thoma's blog, Economist's View.
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