The Dangers of Deficit Reduction

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
yesterday's 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.

Faster growth and returns on public investment yield higher tax
revenues, and a 5 to 6 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.

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.

As the global economy returns to growth, governments should, of
course, have plans on the drawing board to raise taxes and cut
expenditures. The right balance will inevitably be a subject of
dispute. Principles like "it is better to tax bad things than good
things" might suggest imposing environmental taxes.

The financial sector has imposed huge externalities on the rest
of society. America's financial industry polluted the world with
toxic mortgages, and, in line with the well established "polluter
pays" principle, taxes should be imposed on it. Besides,
well-designed taxes on the financial sector might help alleviate
problems caused by excessive leverage and banks that are too big to
fail. Taxes on speculative activity might encourage banks to focus
greater attention on performing their key societal role of
providing credit.

Over the longer term, most economists agree that governments,
especially in advanced industrial countries with aging populations,
should be concerned about the sustainability of their policies. But
we must be wary of deficit fetishism. Deficits to finance wars or
giveaways to the financial sector (as happened on a massive scale
in the U.S.) lead to liabilities without corresponding assets,
imposing a burden on future generations. But high-return public
investments that more than pay for themselves can actually improve
the well-being of future generations, and it would be doubly
foolish to burden them with debts from unproductive spending and
then cut back on productive investments.

These are questions for a later day -- at least in many
countries, prospects of a robust recovery are, at best, a year or
two away. For now, the economics is clear: Reducing government
spending is a risk not worth taking.