Is It Time For Fiscal Austerity?

As economic growth in some developed countries falters once again in the third quarter of this year, especially in the United States and the United Kingdom, the debate surrounding fiscal austerity is becoming less fierce now than it was back in July when the growth rates of developed countries beat market expectations. However, the central problem remains: should governments focus on balancing the largest budget deficits ever seen during peace time by cutting government spending and raising taxes? This debate plays an essential role in shaping governments’ short-term and long-term policy, as well as setting expectations among investors and consumers. At first glance, arguments from both sides of the debate seem have merit.

Those who are in favour of immediate fiscal austerity (the “Austerians”) argue that the oversized deficits in some of the largest developed countries, notably the US and the UK – of a dimension never before seen in peacetime countries - threaten long-term fiscal credibility and depress private confidence and spending. Hence, a smaller budget deficit will potentially stimulate growth. In addition, balancing the budget must be an important priority as other issues, such as aging populations, the cost of healthcare and market confidence will urgently need to be addressed as the economy recovers.

The counter-argument from those who oppose immediate fiscal tightening (the “Postponers”) is not that there is no need to balance the budget – most of them agreed that there must be decisive action to reduce the budget gap. However, they argue that the fragility of economies such as the US and UK means that there is a significant likelihood of a double-dip if governments cut back on spending now. Furthermore, given that interest rates close to zero in the US and the UK, conventional monetary policy is ineffective, except to the extent that it supports fiscal loosening. The danger is that premature fiscal tightening would trigger a sharp economic slowdown, as in Japan in the 1990s, thus pitching these economies into deflation. The risk is particularly significant if all developed countries tighten at the same time.

Postponers such as Paul Krugman also assert that much of the deficit is the result of the ongoing economic crisis, which has depressed revenues. As the economy recovers, the deficit will narrow. Imposing fiscal austerity now may in fact make the deficit worse, as a double-dip recession would further depress revenue.

As of last week, third-quarter economic indicators seem to direct policy makers toward agreeing with the Postponers. A report from the Financial Times points out that the US lost 95,000 jobs in September, which briefly pushed the dollar to its lowest level since 1995. In addition, “the private sector created a modest 64,000 jobs, well below the 300,000-400,000 a month needed to keep up with population growth and tackle rapidly the 9.6 per cent unemployment rate,” said the FT. Thus, the US Federal Reserve has recently signaled the possibility of a second round of “quantitative easing”, the creation of money pumped into the domestic economy by the purchase of government bonds, in order to rescue the faltering American economy.

In the UK, the National Institute of Economic and Social Research estimated that growth in the three months to the end of September was just 0.5 per cent, in contrast with the 1.2 per cent recorded in the second quarter and below the 0.6 per cent measured by official data for the three months to the end of August. Last Friday, George Osborne, the UK chancellor, stated for the first time to the Bank of England’s monetary policy committee that he would not stand in the way of a second round of quantitative easing. However, it is uncertain to what extent the renewed slow-down will affect the government’s next round fiscal tightening, due to be announced later this month.

A critical policy question would then be: when is the right time for governments to cut spending, given that inflation may pick up unpredictably?

Paul Krugman contends that budget deficits should become a priority when, and only when the Federal Reserve has regained some traction over the economy, so that it can offset the negative effects of tax increases and spending cuts by reducing interest rates. At the moment, the Federal Reserve cannot do this because interest rates, being near zero, cannot go any lower.  Although a similar argument can be made for the UK, its budget deficit, at £13.3 billion in August 2010, is much larger in relation to the size of the economy, forcing the UK government to cut spending much sooner in order to avoid further downgrades in rating to the Sterling.

In the meantime, global microeconomic reforms are inevitable if the world economy is to grow in a more sustainable way. Emerging economies need to allow their currencies to rise. China, in particular, must boost investment in services, remove trade distortions and promote domestic consumption. On the other hand, rich countries should tread carefully with fiscal consolidation – sensible budget repair should be less about short-term deficit-slashing and more about lasting fiscal reforms, from raising the retirement age to trimming health care costs that depress workers’ share of income and encourage households to save less. Otherwise, attempts to cut spending now will bring about the very consequence that they meant to avoid – a further widening of the budget gap and quite possibly a second economic recession.