The Self-Defeating Fiscal Adjustment Debate in a Depressed Economy
This post was written by John McHale
The paper “Fiscal Policy in a Depressed Economy” by Delong and Summers (from the BPEA conference linked to by Philip) is hugely relevant to the Irish fiscal policy debate. While the paper ranges more widely, it provides a useful framework for thinking about the question of whether fiscal adjustment could actually be self defeating in terms of lowering “long-run debt financing burdens” in a depressed economy with interest rates constrained by a zero nominal lower bound. Indeed, the analysis would seem to have even more general relevance for a small economy within a large monetary union, where the nominal policy interest rate is effectively a given. A key message is that “hysteresis effects” – whereby today’s output level could have long-lasting effects on future output – could make higher deficit spending today pay for itself over the longer term. In such a world, a slower pace of deficit reduction need not have an adverse impact on creditworthiness.
There is a kicker on page 40, however, that is very relevant to the Irish debate.
There remains the question, on which our analysis is mute, of whether temporary fiscal stimulus is inconsistent with a perception of long run fiscal consolidation. There is no necessary inconsistency. There is experience with temporary expansions, and also with phased-in long-run deficit reductions (e.g. The 1983 Social Security bipartisan agreement of the Greenspan Commission). But it is possible that short run fiscal expansion undercuts the credibility of long-run fiscal consolidation. It is also possible that, in a world with limited political energy and substantial procedural blockages, that effort towards one objective compromises the other. On the other hand, as Cottarelli (2012) warns, if countries that have committed themselves to short-term deficit reduction as a down payment on a move to long-term sustainability find that “if growth slows more than expected… [they are] inclined to preserve their short-term plans through additional tightening, even if hurts growth more” then: “my bottom line:… unless you have to, you shouldn’t.” His fear is that fiscal austerity will be counterproductive because “interest rates could actually rise [even] as the deficit falls” if “growth falls enough as a result of a fiscal tightening.”
We do not see a good way to address this issue analytically or empirically. Clearly, the risks of short run fiscal stimulus having adverse effects on long-run credibility will be greater in settings where government debt already carries a significant risk premium. Clearly, it will be larger when there is evidence that deficit fears are impacting on stock market valuations and on investment decisions. But even in the absence of such evidence, there is always the risk that market psychology can change suddenly.
I would be interested in people’s views.