The Painful Art of Fiscal Consolidation

One of the most influential ideas in economic thinking in the 20th century was the so-called Laffer Curve which rejected the idea of a liner relationship between tax rates and tax revenues. Instead, the argument goes, when taxes are increased beyond a certain level, tax revenues actually begin to drop as people begin to evade taxes, become discouraged and work less due to the declining financial reward from additional effort.

This echoed the notion of ‘liquidity trap’ developed by John Maynard Keynes in the 1930s. Keynes argued that under certain circumstances, typically at very low interest rates, monetary policy loses its ability to stimulate the economy and further progress is only possible through fiscal stimulus. Both concepts highlight the obvious reality that many economic relationships are not linear, or at least not consistently so. Another potential non-linearity which is increasingly troubling investors and policy-makers has to do with the effectiveness of fiscal stimulus.

While government spending can in principle support aggregate demand and smoothen economic cycles, is it possible that its ability to do so begins to diminish when governments begin to run large deficits? At that point, the cost of funding debt tends to rise because of its growing supply and concerns about ability to pay. Moreover, consumers and investors alike may begin to lose their faith in economic policy, knowing that the borrowing will have to be repaid somehow, some day – the idea known as ‘Ricardian equivalence’ after the 19th-century economic thinker David Ricardo. One of the challenges of economic policy today is the sharp divergence of opinion between people believing in Ricardian equivalence in its pure form and those advocating government stimulus as a potent tool to ensure aggregate demand. The truth, as so often, may well lie between the two extremes.

Nonetheless, given the rigid ideological views at stake in the debate, there is little consensus on the need for and magnitude of fiscal consolidation four years into the global economic crisis. The response to the crisis marked a renewed triumph of Keynesianism, the idea that fiscal stimulus – amplified by loose monetary policy – could restore the normal operations of a crisis-struck economy. Problematically, by serving as the ultimate line of defense during the economic crisis, fiscal policy has involved the nationalisation of many of the pre-crisis structural problems but not to their solution or even meaningful diminution. When the financial sector run into difficulty, leading banks in many countries were either nationalized or received significant support. Yet banks are yet to meaningfully re-engage in financial intermediation.

Government investment became a way of protecting jobs and supporting aggregate demand. Frustratingly, what was intended as a temporary measure is yet to give way to a sustained private sector recovery. As a painful reminder of this reality, the US economy added only 18,000 new jobs in June, a tenth of what would be needed for the labour market to begin to normalise as new monthly entrants alone total some 125,000. This followed a similarly modest addition of 25,000 jobs in May in a marked departure from three months of figures in the neighbourhood of 200,000. With growing financial woes in the public sector, especially at the sub-federal level, government payrolls are likely to continue to be cut.

The effectiveness of the Keynesian revival has been limited by the fact that the crisis is in essential ways a balance sheet recession. People will not spend and companies will not invest unless they feel that they can afford it. Especially in the personal sector, the erosion of asset values has not only been substantial but is still ongoing in a number of key markets. There is little in this environment to encourage renewed borrowing. Under the circumstances, while government spending can offer continuity, there are legitimate doubts as to its effectiveness and sustainability. While US household debt has fallen to 115 per cent of real disposable income from a pre-crisis peak of 130 per cent, it is far above the 1975-2000 average of 75 per cent. It could take years for things to normalise.

Many countries have now reached a point where they can simply no longer afford more fiscal stimulus as increasing the deficit undermines the government’s credibility and increases the cost of borrowing. Hence, even though the economies of many Western countries are barely out of the recession, they are busy reversing the fiscal stimulus. President Obama has already admitted that federal tax increases are necessary if the US is to have any hope of once again balancing its books. Problematically, the pain threshold of most politicians and voters is low. Increasing taxes will be painful given the central role of tax cuts over the past two decades in stimulating economic activity and boosting people’s spending power.

Moreover, tax increases can easily undermine a country’s competitiveness in the eyes of foreign – and domestic – investors. One potential way out is a tax reform that seeks to increase the efficiency of the current tax system to generate income by reducing the administrative burden and closing inefficient loopholes. For instance the US has costly exemption for pensions and health insurance which cost some $300bn. Benefits for charities total $100bn and various other loopholes some $150bn. The economic benefits of such measures can be doubtful and the distortions caused by them potentially significant, even if some of them will doubtless be much more difficult to reform than others.

Even as Europe struggles with its own debt woes, the debate on the future direction of economic policy has become particularly vocal and polarised in the US where the Congress recently voted to increase the federal debt limit of $14.3trn, which was reached on 16 May. Nonetheless, a profound difference of opinion persists as to the way in which the growing debt burden should be contained. The Democrats insist on tax increases while the Republicans want to scale back the government. In an intensely partisan environment, many Republicans would like to force the administration into structural cuts of the costly entitlement schemes such as Social Security and Medicare.

The stage looks set for a potentially economically disruptive political drama. There is little to suggest that the pre-election maneuvering will create the basis for something much more than stopgap measures. At the same time, the political rhetoric is shifting in favour of fiscal consolidation, partly out of sheer necessity, partly because of President Obama’s need to seek support from Republican sympathisers. The main risk is one of the US falling between two stools. The country’s ability to sustain additional stimulus will be minimal while the fiscal consolidation measures risk being too piecemeal to impress anyone. With money running out and investors growing sceptical, the chances that the US will go through a painfully slow and uneven recovery are increasing. Its best hope may well be that its own problems will be eclipsed by those of others, which should offer some support to investor demand.

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