The Dangers of Deficit Reduction

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NEW YORK—A wave of fiscal austerity is rushing over Europe and America. The magnitude of budget deficits—like
the magnitude of the downturn—has taken many by surprise. But despite protests by proponents of deregulation, who would like the government to remain passive, most economists believe that government spending has made a difference, helping to avert another Great Depression. Most economists also agree that it is a mistake to look at only one side of a balance sheet (whether for the public or private sector).

One has to look not only at what a country or firm owes, but also at its assets. This should help answer those financial sector hawks who are raising alarms about government spending. After all, even deficit hawks acknowledge that we should be focusing not on today’s deficit, but on the long-term national debt. Spending, especially on investments in education, technology, and infrastructure, can actually lead to lower long-term deficits.

Banks’ short-sightedness helped create the crisis; we cannot let government short-sightedness—prodded by the financial sector—prolong it. Faster growth and returns on public investment yield higher tax revenues, and a five to six percent return is more than enough to offset temporary increases in the national debt. A social cost-benefit analysis (taking into account impacts other than on the budget) makes such expenditures, even when debt-financed, even more attractive. Finally, most economists agree that, apart from these considerations, the appropriate size of a deficit depends in part on the state of the economy.

A weaker economy calls for a larger deficit, and the appropriate size of the deficit in the face of a recession depends on the precise circumstances. It is here that economists disagree. Forecasting is always difficult, but especially so in troubled times. What has happened is (fortunately) not an everyday occurrence; it would be foolish to look at past recoveries to predict this one. In America, for instance, bad debt and foreclosures are at levels not seen for three-quarters of a century; the decline in credit in 2009 was the largest since 1942. Comparisons to the Great Depression are also deceptive, because the economy today is so different in so many ways. And nearly all so-called experts have proven highly fallible—witness the United States Federal Reserve’s dismal forecasting record before the crisis.

Yet, even with large deficits, economic growth in the U.S. and Europe is anemic, and forecasts of private-sector growth suggest that in the absence of continued government support, there is risk of continued stagnation—of growth too weak to return unemployment to normal levels anytime soon. The risks are asymmetric: if these forecasts are wrong, and there is a more robust recovery, then, of course, expenditures can be cut back and/or taxes increased. But if these forecasts are right, then a premature “exit” from deficit spending risks pushing the economy back into recession. This is one of the lessons we should have learned from America’s experience in the Great Depression; it is also one of the lessons to emerge from Japan’s experience in the late 1990’s. These points are particularly germane for the hardest-hit economies.

The full article originally appeared at Joseph Stiglitz. 

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