Christine Lagarde, managing director of the International Monetary Fund, argued last month that “markets dislike high public debt … but they dislike low or negative growth even more.” The discussions at the central bankers’ annual gathering in Jackson Hole reflected this dilemma. As growth declines across the globe, the case for immediate, worldwide fiscal retrenchment to fight the debt scare in advanced economies and overheating in emerging markets has weakened. The debt problem remains, however. For the advanced countries, many agree with the IMF that a balanced approach is called for, emphasizing the need for short-term fiscal stimulus in the United States and parts of Europe, combined with long-term structural reforms and fiscal retrenchment. In emerging markets, slowing growth is becoming more of a concern than overheating.
One should beware, however, of a naive version of the “stimulate now, retrench later” argument. Companies and households do not base spending decisions on immediate income and incentives only. They do look ahead. An immediate tax cut, matched by an expectation of tax increases two or three years from now, is unlikely to be expansionary. One does not have to be a strong believer in what economists call “Ricardian equivalence,” to expect economic agents to look at prospects over a few years when making their spending decisions, rather than at their immediate income only. This means that the high debt overhang in many of the advanced economies, which makes fiscal retrenchment unavoidable over time, is of itself a brake on private spending and makes it difficult to stimulate in the short run. Some argue, therefore, that there is no way out of the current crisis and that we have to endure a prolonged slowdown, because short term stimulus will be self-defeating.
To solve the fiscal conundrum, one has to look beyond aggregates at details and structure. In the United States, for example, immediate tax breaks accompanied by the promise or strong expectation of future tax increases cannot be an effective stimulus, unless targeted on the poorest, who tend to spend whatever they can. On the contrary, federal or state spending to improve infrastructure, whose cost could be recovered through tolls or other charges, and which would also raise productivity in the private sector, could be strongly expansionary if well designed. After all, the government today can borrow at real interest rates close to zero. If the financial rate of return on investment so financed is modestly positive, such spending will actually improve the public sector’s balance sheet, reducing future pressure to tax. Moreover, the economic return on good infrastructure will be greater than the financial return to the public sector alone, because of its positive effects on the activity and income of private sector businesses, both small and large.
Structural reforms of entitlements can also contribute to the recovery, if they succeed in making the system more sustainable without creating a fear of the future among the broad middle class. For example, raising the age of access to Medicare, by itself, may not pass that test. It would save money and appear to reduce future debt, but that could be offset, at least in part, by increased anxiety among those with insufficient medical coverage, leading them to cut back spending at once and so reducing growth. A more targeted reform of Medicare, with greater cost sharing by those most able to afford it, would have the same effect in reducing debt with less deflationary anxiety.
Simplicity is generally a virtue, but there can be too much of a good thing. Neither fiscal stimulus nor fiscal retrenchment is the answer to our current dilemma. Stimulate now and announce future retrenchment can be the answer. But the stimulus must be targeted to lead to an immediate rise in effective demand and be mindful of the public balance sheet, while the retrenchment must not create anxiety about the future that would nullify the stimulus. Taking into account the likely response of different groups and distinguishing between public investment and pure consumption is key for both measures.