Europe seems to be obsessed with austerity. Country after country is being forced by either the financial markets or the EU to start cutting its public-sector deficit. And, as if this were not enough, 25 of the 27 EU member states have just agreed on a new treaty (called a “fiscal compact”) that would oblige them never to have a cyclically adjusted budget deficit of more than 0.5 percent of GDP. (For comparison, the US’ budget deficit last year was close to 8 percent of GDP).
However, as the European economy risks falling into recession, many observers are asking whether “austerity” could be self-defeating. Could a reduction in government expenditure (or an increase in taxes) lead to such a sharp decline in economic activity that revenues fall and the fiscal position actually deteriorates further?
This is highly unlikely, given the way our economies work. Moreover, if it were true, it would follow that tax cuts would reduce budget deficits, because faster economic growth would generate higher revenues, even at lower tax rates. This proposition has been tested several times in the US, where tax cuts were invariably followed by higher deficits.
In Europe, the concern today is instead with the debt/GDP ratio. The worry here is that the GDP drop resulting from “austerity” might be so large that the debt ratio increases. This matters, because investors often use the debt ratio as an indicator of financial sustainability. Thus, a lower deficit might actually heighten tensions in financial markets.
However, a lower deficit must lead over time to a lower debt ratio, even if this ratio worsens in the short run. After all, most models used to assess the economic impact of fiscal policy imply that a cut in expenditure, for example, lowers demand in the short run, but that the economy recovers after a while to its previous level. So, in the long run, fiscal policy has no lasting impact (or only a very small one) on output. This implies that whatever short-run negative impact lower demand may have on the debt ratio should be offset later (in the medium to long run) by the rebound in demand that brings the economy back to its previous output level.
Moreover, even assuming that the impact of a permanent cut in public expenditure on demand and output is also permanent, the GDP reduction remains a one-off phenomenon, whereas the lower deficit continues to have a positive impact on the debt level year after year.
Notice that this conclusion was reached without any recourse to what Paul Krugman and others have derided as the “confidence fairy.” In the US, it might indeed be unreasonable to expect that a lower deficit translates into a lower risk premium — for the simple reason that the US government pays already ultra-low interest rates.
However, even without any confidence effects, the bipartisan Congressional Budget Office has concluded that, while cutting the US deficit does lower demand, it still leads reliably to a lower debt ratio. This should be all the more true for eurozone countries, like Italy or Spain, that are now paying risk premiums in excess of 3 percent to 4 percent. For these countries, the confidence fairy has become a monster.
The decisive question then becomes: What matters more, the impact of deficit cutting on the debt/GDP ratio in the short run or in the long run?