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Friday, June 24, 2011

Short-Run Deficit Reduction is *Not* Expansionary

The empirical evidence behind the expansionary austerity claims can be challenged, but even if you accept it at face value it doesn't imply the US would benefit from pursuing immediate deficit reduction:

Fiscal Contraction Hurts Economic Expansion, by Simon Johnson, Commentary, NY Times: 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...

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

The general presumption is that fiscal contraction ... will immediately slow the economy relative to the growth it would have had otherwise. ... But some studies have found that ...[u]nder 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... But the United States is currently among the countries with the lowest perceived risk...

Second, it is highly unlikely that short-term spending cuts would directly increase confidence among households or companies... The United States still has a significant “output gap”... Fiscal contractions rarely inspire confidence in such a situation.

Third, if monetary policy becomes more expansionary while fiscal policy contracts... But ...[i]t is unclear that much more monetary policy expansion would be advisable, or possible, in the view of the Fed, even if unemployment increases again — as it might if fiscal contraction involves laying off government workers.

Fourth, tighter fiscal policy and easier monetary policy can, in small, open economies with flexible exchange rates, push down (that is, depreciate) the relative value of the currency — thus increasing exports... But this is unlikely to happen in the United States, in part because other industrialized countries are also undertaking fiscal policy contraction. ...

The available evidence, including international experience, suggests it is very unlikely that the United States could experience an “expansionary fiscal contraction” as a result of short-term cuts in discretionary domestic federal government spending. ...

    Posted by on Friday, June 24, 2011 at 12:42 AM in Economics, Fiscal Policy | Permalink  Comments (60)


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