[Viewpoint] The Anglo-Saxon budget laboratoriesThe recent threat of a downgrade of the United States’ public debt by the rating agency Standard and Poor’s was a bolt from the blue. Once confined to a few delinquent countries, worries about public debt are now bearing down on the world’s biggest and richest economies.
The message to all governments is clear: if the quality of even U.S. bonds, traditionally the safest of financial assets, can be questioned, no country is immune from attack. So, the question today is not whether it is time to reduce deficits, but how fast, how far and by what means.
In Europe, German Chancellor Angela Merkel is portrayed as a tough deficit cutter. But while she likes to raise her voice, she acts with caution: today’s German fiscal adjustment is, in fact, very gradual. The countries where the budget battle will be hard fought are the United Kingdom and the U.S., where deficits exceeded 10 percent of GDP in 2010.
In London, Prime Minister David Cameron is on the offensive. On assuming office, he entrusted budgetary forecasting to an independent Office for Budgetary Responsibility (OBR), thus forfeiting any possible sleight-of-hand. He then announced a bold consolidation program to cut the cyclically adjusted deficit by 1.5 percent of GDP per year, thereby targeting a deficit of 3.5 percent of GDP in 2013.
Cameron’s bet was that this adjustment would stimulate, not hinder, growth. Since Ireland and Denmark showed the way 25 years ago, numerous governments have dreamed of successful “expansionary budgetary contractions.” But a closer look at these oxymoronic, quasi-miraculous episodes reveals that, for the usual recessionary impact of fiscal consolidation to be eliminated or even reversed, at least one of three conditions must be met: households’ precautionary savings decline; long-term interest rates fall; or a more expansionary monetary policy weakens the exchange rate.
Absent these conditions, budgetary adjustments are almost always costly in terms of growth. This was confirmed by a recent careful and detailed study, carried out by the International Monetary Fund, of past consolidation episodes.
In the U.K., no drop in precautionary savings can be counted upon (households are heavily in debt, so they need to save more, not less), and long-term interest rates are already very low. That leaves only monetary policy to support economic activity. But, owing partly to surging commodity prices and partly to weak productivity gains, U.K. inflation is higher than expected, and the Bank of England forecasts that it will be around 3 percent at the start of 2012 - almost two points higher than the Bank’s projection last year.
Indeed, the Bank of England’s latest inflation report makes it clear that, in such a context, interest-rate hikes are likely. So it is suddenly very difficult for the U.K. to promote economic growth, which has been stagnant for the two last quarters. Cameron’s bet is not yet won, to say the least.
The U.S. stance has been entirely different. Faced with unemployment close to the post-WWII maximum, Barack Obama’s administration has delayed adjustment in order to avoid smothering recovery. It even gave the economy a further boost at the end of 2010, in part to offset the highly restrictive policies of America’s 50 states, most of which have balanced-budget rules and thus run highly pro-cyclical policies.
To continue stimulating in the short term was a perfectly defensible choice by Obama but it made the lack of any serious thinking about the manner and speed of future consolidation starkly apparent. Until recently, the feeling of urgency that pervades European policy making was almost entirely absent in the U.S. All of the ideas afoot lacked any political traction.
A new phase commenced with the recent last-minute agreement to avoid a shutdown of the federal government, and the approval by the House of Representatives of the budgetary program proposed by Republican Congressman Paul Ryan. The budget debate is now in full swing. But the objective remains relatively unambitious, and, more importantly, disagreements about the means to achieve it are huge.
The Obama administration is advocating a balanced approach, whereby two-thirds of the adjustment comes from spending cuts and one-third from tax increases. The Ryan plan, however, provides for a steeper reduction in the budget, in particular cuts in social spending that would finish off what remains of the U.S. welfare state and finance a cut in taxes.
As a result, a kind of war of attrition is now being waged. Both sides are focusing on the state of public finances but each camp is seeking to use the deficit to push its own preferences regarding the future of revenues and spending and to compel the other side to back down. Unfortunately, as the economists Alberto Alesina and Alan Drazen illustrated in a famous paper two decades ago, this is exactly the type of political configuration that leads to delay in budgetary adjustments. The battle is intrinsically political. It is also uneven because those whose ambition is to shrink the state are by definition more prepared to risk bankrupting it than are those who seek to preserve it. Indeed, the Obama administration has already made major concessions on tax reductions and spending cuts.
Once again, the U.K. and the U.S. are acting as laboratories for the rest of the world. The fate of the UK experiment will critically influence other countries’ resolve to embark on large-scale adjustments; the outcome of the U.S. battle will influence choices about the relative priority of spending cuts and tax increases. The results of these experiments will have major consequences for policy makers elsewhere.
*Copyright: Project Syndicate, 2011.
The writer is director of Bruegel, an international economics think tank, and professor of economics at Universite Paris-Dauphine.
By Jean Pisani-Ferry