Doing Deficit Reduction Right

Federal Reserve Chairman Ben Bernanke and the non-partisan Congressional Research Service (CRS) reminded policymakers this week that sharp, immediate cuts in government spending are the wrong way to reduce deficits.

In this speech, Chairman Bernanke laid out the mainstream economic view of how to deal with a weak economy and an unsustainable long-term trajectory for federal budget deficits and debt:

If the nation is to have a healthy economic future, policymakers urgently need to put the federal government’s finances on a sustainable trajectory.  But, on the other hand, a sharp fiscal consolidation focused on the very near term could be self-defeating if it were to undercut the still-fragile recovery.  The solution to this dilemma, I believe, lies in recognizing that our nation’s fiscal problems are inherently long-term in nature.

Consequently, the appropriate response is to move quickly to enact a credible, long-term plan for fiscal consolidation.  By taking decisions today that lead to fiscal consolidation over a longer horizon, policymakers can avoid a sudden fiscal contraction that could put the recovery at risk.

Our framework for deficit reduction reflects this mainstream economic view.  Most Republican policymakers, however, want to slash federal spending and declare revenue measures off the table in budget discussions.

Their economic defense seems to be based on two beliefs at odds with mainstream economics.  First, despite a host of Republican economists telling them otherwise, Republican policymakers can’t resist arguing that tax cuts pay for themselves.  That’s the old voodoo economics.  The second belief — the new voodoo economics — is that cutting government spending will create jobs and lower unemployment in the short term.

A new CRS report, “Can Contractionary Fiscal Policy Be Expansionary?” takes on the main evidence used to support this latter belief:  an international study by Harvard economists Alberto Alesina and Sylvia Ardagna suggesting that cutting spending to shrink deficits needn’t slow the economy in the short term.  Here are CRS’s main conclusions (the study will soon be posted here):

The [finding] in the Alesina and Ardagna study that successful debt reductions were associated with higher growth when spending cuts were used was based on 9 observations out of 107 instances of deficit reduction, or less than 10% of the sample.  In addition, most of the countries where debt reductions were successful were at or close to full employment, while the United States remains well below full employment, raising questions as to whether this evidence is applicable to U.S. conditions.

Reducing the deficit while the economy is still fragile…would likely involve further contraction that might not be desirable.  At the same time, the sooner long-run debt problems are addressed, the more room there is for the adjustments to be implemented gradually.  The mix of policies (tax increases, spending cuts, and the types of either) depend on many factors including preferences for public programs and distributional objectives as well as growth.

It’s time for policymakers to show they can bring down the long-term budget deficit without making it even harder to bring down the jobs deficit.