Thursday, July 15, 2010

Fiscal adjustment: fast or slow?

As growth slowly comes back governments in advanced economies are facing the question of when they should start reducing their deficit and address the growing debt problems. While there is no question about the need for an adjustment, there is a debate about its timing and speed. These are the two sides of the debate:

1. Go slow: given that growth is still not strong enough and unemployment remains high, adjustment should be postponed as much as possible. A cut in government spending or an increase in taxes will decrease aggregate demand and growth. The costs of keeping the debt high are small compared to the costs of high unemployment.

2. Governments need to act fast because their high level of deficits and debt are creating too much uncertainty and fear of a crisis. In some cases this is showing up as higher interest rates (which can harm growth). In others, interest rates remain low but the fear of an unsustainable path for fiscal policy can lead to low investment and growth. A quick fiscal consolidation (reduction in deficits) is what the economy needs now.

Both sides of the argument have merits and it is not a question of which one is right and which one is wrong. Circumstances are different in each country and it is likely that the optimal speed of adjustment is different for each economy. What I would like to highlight in this post is an area where I feel there is some misperception: the burden that interest payments on the debt impose on taxpayers, an argument that is used in favor or speeding up the fiscal adjustment.

It is possible, although empirically it is not that obvious, that a high level of government debt has negative consequences on investment or economic growth. The high level of government debt can be seen as an accumulation of previous errors or misbehavior: governments spent too much or did not have the political willingness to collect enough taxes. But the past cannot be changed and the question we face now is how to pay for our previous “mistakes”: Do we do go for a quick payment of our debt or do we spread the pain over a long number of years? This is an economic decision that depends on many parameters but mainly on the relative value of current versus future income and the interest rate that we are charged on the debt (which in general equilibrium they have to be related). What we need to understand is that the cost of the debt will be there whether we pay now or we pay later. We might find good reasons why we should pay earlier but there might also be reasons why we want to postpone the payment (spread the pain over several years).

Think about an individual who inherits some debt or that realizes that the total value of his debt is higher than what he initially thought. Is there an economic argument that he should cut his consumption as much as possible to avoid the higher interest payments on the debt? Not clear. This decision is about the trade off between consuming today and tomorrow and the price at which this trade off takes place. In most economic models, we assume utility functions for individuals that generate a preference for consumption smoothing, so we normally think about an optimal solution that requires slow payment of the debt. Same for governments, we normally think about tax decisions as being driven by a “tax smoothing” argument, which suggests that spreading the burden of high debt over many years or decades, is optimal. In addition, if we think about the present as a period where income is unusually low (because of the recession), this might not be the right time to start paying off our debts by cutting our consumption even more.

In summary, one needs to be careful using the argument of the high burden of the debt to push for a quick reduction in government debt levels. The level of government debt is what it is and the burden will have to be paid in some form over the future. The question on how fast we reduce the debt is about the timing of those payments and not so much about the total cost of the debt. Paying earlier has to be a statement about how we are willing to cover the cost of debt with reduced current spending as opposed to reduced future spending.

Of course, if financial markets are not willing to fund our debt anymore, we will be obliged to pay the debt faster. Or, in a milder scenario, if the interest rate we face is “unreasonably” high because of the fear of default, we might find it optimal to pay the debt now to calm that fear and reduce the overall burden of the debt – this might apply to Greece but it clearly does not apply to the US.

Antonio Fatás

on July 15, 2010 |   Edit