Why Consolidate?

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Around the world, raging debates about whether, when, how,and how much to reduce large budget deficits and high levels of sovereign debtare dividing policymakers and publics. Diametrically opposed spending, tax,monetary, and regulatory policies and proposals are proliferating. To consolidate (the budget),or not to consolidate, that is the question.
The political left clamors for more spending, higher taxeson high-income earners, and delayed fiscal consolidation. For example, the economistand New York Timescolumnist Paul Krugman proposes waiting 10-15 years. (Many of the same peopleargued for analogous reasons against the Federal Reserve’s successfuldisinflation policies in the early 1980’s.) The political right calls for morerapid deficit reduction by cutting spending.
In Europe, policymakers, including the European CentralBank, demand consolidation for high-debt countries, but are flexible innegotiations; voters, however, reject it – most recently in Italy. In theUnited States, Republicans propose to balance the budget within ten years byreforming entitlement spending and taxes (with fewer exemptions, deductions,and credits providing the revenue needed to reduce personal tax rates and acorporate rate that, at 35%, is the highest in the OECD).
America’s Senate Democrats propose $1.5 trillion in highertaxes over ten years (on top of the $600 billion agreed in early January), $100billion (twice that, for House Democrats) in new stimulus spending, and modestlonger-term expenditure cuts. Their version of tax reform would mean reducingdeductions for the wealthy and corporations, with no rate reductions.
What are the likely costs and benefits of stimulus versusconsolidation? And what is the best combination of spending cuts and tax hikes?
Economists agree that, at full employment, highergovernment spending crowds out private spending. Keynesian models claiming aquick boost from higher government spending below full employment show that theeffect soon turns negative. So it needs to be repeated over and over, like adrug, to sustain the economic high. That strategy saddled Japan with theworld’s highest debt/GDP ratio, to little benefit.
To be sure, recent research suggests that increasedgovernment spending can be effective in temporarily raising output andemployment during deep, long-lasting recessions when the central bank hasreduced its short-term policy interest rate to zero. But the same researchsuggests that the government spending multiplier is likely to be small or evennegative in a variety of circumstances and, in any event, would quickly shrink.
Such circumstances include, first, a high debt/GDP ratio,with rising interest rates impeding growth. Likewise, during expansions, highergovernment spending is more likely to crowd out private spending. Spending ontransfer payments and/or nonmilitary purchases – which can become entrenched orbe procured more cheaply from abroad (for example, solar panels and windturbines, respectively, in America’s 2009 fiscal stimulus) – is also likely toyield only a small multiplier. And, when the economy has flexible exchangerates, if government spending raises interest rates, the currency willstrengthen, leading to a decrease in investment and net exports. Finally, theeffects of additional government spending may be offset by people’sexpectations of higher taxes once the central bank exits the zero lower boundon interest rates (causing them to spend less now).
These considerations apply to the US and some Europeancountries today. Together with poor design, they explain why America’s 2009stimulus cost several hundred thousand dollars per temporary job created.
Recent research also reveals that in OECD countries sinceWorld War II, successful fiscal consolidation – defined as stabilizing thebudget while avoiding recession – averaged $5-$6 of actual spending cuts perdollar of tax hikes. Cuts in spending, especially on entitlements and transfers,were far less likely to cause recessions than tax increases were.Unfortunately, tax hikes have predominated in many recent Europeanconsolidations, including last week’s proposed Cyprus bailout.
Of course, caution is appropriate in order to avoidclaiming too much for the benefits of short-run consolidation. After all, thecurrent American and European economies differ in important ways from the otherpost-war cases – size, simultaneous consolidation in many countries,already-low interest rates, and the dollar’s status as the main global reservecurrency.
But, other than in deep recessions, the validity of theKeynesian claim that delaying spending cuts is necessary to avoid underminingthe economy is at best unclear, and would leave a long boom as the only time tocontrol spending. And large deficits and high debt levels decrease theprospects for a long boom. Moreover, credibly phasing in spending reductions asthe economy recovers is no easy task, given the political economy of the budgetand the inability of one legislature to bind the next.
Worse yet, the cost of delay and increased deficits anddebt is enormous. For example, without major reform in the US entitlementprograms – which are exploding in size as a result of rising real benefits perbeneficiary and an aging population – the next generation can expect a 20%reduction in living standards.
The most credible reforms are structural – for example,higher retirement ages and changes to benefit formulas – and difficult to alteronce they are implemented. Merely setting a dollar (or pound or euro) targetfor budget cuts is far less effective, because the target can easily be revised– and cuts reversed – to avoid political pain.
If there were some short-term stimulus that was timely andlikely to raise output and employment at a reasonable long-term cost, I wouldbe all for it. But the evidence is that highly effective fiscal policy, even atthe zero lower bound on interest rates, remains at best a theoreticalpossibility, subject to severe political constraints. While consolidation mayimply some short-term costs, especially in a recession, the long-term costs ofdelay are large. It would be best if a credible consolidation program could bephased in gradually; but consolidation needs to proceed nonetheless – andprimarily by controlling spending.

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关键词：consolidate Solid date ATE con regulatory political debates example whether

Around the world, raging debates about whether, when,how, and how much to reduce large budget deficits and high levels of sovereigndebt are dividing policymakers and publics.
The political left clamors for more spending, highertaxes on high-income earners, and delayed fiscal consolidation.The political right calls for more rapid deficit reductionby cutting spending.



What are the likely costs and benefits of stimulus versusconsolidation? And what is the best combination of spending cuts and tax hikes?
Economists agree that, at full employment, highergovernment spending crowds out private spending.To be sure, recent research suggests that increasedgovernment spending can be effective in temporarily raising output andemployment during deep, long-lasting recessions when the central bank hasreduced its short-term policy interest rate to zero. But the same researchsuggests that the government spending multiplier is likely to be small or evennegative in a variety of circumstances and, in any event, would quickly shrink.
Such circumstances include, first, a high debt/GDP ratio,with rising interest rates impeding growth. Likewise, during expansions, highergovernment spending is more likely to crowd out private spending. Spending ontransfer payments and/or nonmilitary purchases – which can become entrenched orbe procured more cheaply from abroad (for example, solar panels and windturbines, respectively, in America’s 2009 fiscal stimulus) – is also likely toyield only a small multiplier. And, when the economy has flexible exchangerates, if government spending raises interest rates, the currency willstrengthen, leading to a decrease in investment and net exports. Finally, theeffects of additional government spending may be offset by people’sexpectations of higher taxes once the central bank exits the zero lower boundon interest rates (causing them to spend less now).



Recent research also reveals that in OECD countriessince World War II, successful fiscal consolidation – defined as stabilizingthe budget while avoiding recession – averaged $5-$6 of actual spending cutsper dollar of tax hikes. Cuts in spending, especially on entitlements andtransfers, were far less likely to cause recessions than tax increases were.Unfortunately, tax hikes have predominated in many recent Europeanconsolidations, including last week’s proposed Cyprus bailout.



The most credible reforms are structural – for example,higher retirement ages and changes to benefit formulas – and difficult to alteronce they are implemented. Merely setting a dollar (or pound or euro) targetfor budget cuts is far less effective, because the target can easily be revised– and cuts reversed – to avoid political pain.Ifthere were some short-term stimulus that was timely and likely to raise outputand employment at a reasonable long-term cost, I would be all for it. But theevidence is that highly effective fiscal policy, even at the zero lower boundon interest rates, remains at best a theoretical possibility, subject to severepolitical constraints. While consolidation may imply some short-term costs,especially in a recession, the long-term costs of delay are large. It would bebest if a credible consolidation program could be phased in gradually; butconsolidation needs to proceed nonetheless – and primarily by controllingspending.