This is an old theme here, but the issue and the confusion persists, as I have just come from attending the Peter G. Peterson Foundation’s fiscal summit today, complete with a protest/press conference on the front steps of the summit venue, with the protesters arguing against the “austerity” measures they think the summit participants and attendees advocate.
Just coincidentally, here is a blog post I wrote on Concord’s blog today. In it, I say deficits can sometimes be good, and deficits can sometimes be bad, depending on the condition of the economy (emphasis added):
In a recovering economy still below “full employment” level, the binding constraint is lack of demand for goods and services. Increasing the supply of productive resources won’t increase GDP if there is already excess supply, or idle capacity, in the economy. It will only increase unemployment. In such an economy, fiscal policy can increase GDP by stimulating consumption — either through the government’s direct purchases of goods and services, or through tax cuts or transfer payments that indirectly increase private spending. Deficit spending can be effective at increasing demand and GDP immediately; how effective it is depends on how well targeted the policies are toward households and businesses most likely to spend additional funds on goods and services, and on how much the industries that produce those goods and services respond by hiring additional workers.
Sudden fiscal consolidation or deficit reduction, on the other hand, can jeopardize an economic recovery if it substantially reduces the net incomes of households that spend most of their income. (Such “austerity” measures can also spur a political backlash, as we are seeing now in Greece and France.)
In contrast, in a fully-recovered, full-employment economy, the size of the economy is limited by the level of productive capacity, or the aggregate “supply side” of the economy. Increasing demand without increasing supply only creates inflationary pressures. Under these conditions, higher private and/or public saving will most effectively expand the economy.
Deficits harm economic growth by reducing national saving (public plus private saving), which reduces the capital stock, labor productivity and household incomes. So deficit financing of tax cuts or spending designed to encourage the supply of productive resources handicaps the likely payoff. If policies can be structured to preserve the positive incentive effects on the supply of labor and capital while avoiding deficit financing, then those policies are much more likely to increase GDP.
As the economy gets closer to full employment and there is less need to stimulate demand, fiscal policy should transition from deficit-financed policies that encourage consumption, to paid-for policies that increase national saving.
And just because deficit spending in general can be helpful in a recession and recovery and harmful in general in a recovered economy, doesn’t mean all deficit spending is equally good in a recession and recovery, or all deficit spending is equally bad in a full-employment economy. There are benefits and costs in either situation that should be evaluated as thoughtfully as possible in order to maximize the net benefits of the policy.
So I don’t support “austere” fiscal policy, but I do keep hoping for “smarter” and (net) beneficial fiscal policy. It is not at all hard to do in economic theory. The difficulty lies mostly in political practice. I’ll explain more on that soon when I write more about what happened at today’s fiscal summit.