Tuesday, March 30, 2010

Misplaced Rectitude

In the FT, Jeffrey Sachs and George Osborne argue that governments need to deal with their budget woes sooner rather than later:
Virtually all policy analysts agree that the path to renewed prosperity in Europe and the US depends on a credible plan to re-establish sound public finances. Without such a plan, the travails which have hit Greece and which are threatening Portugal and Spain will soon enough threaten the UK, US, and other deficit-ridden countries. In the recent duel of macro-economists, one camp has called for early budget consolidation, followed by further measures over five years. We agree. Others want more fiscal stimulus, delaying deficit reduction. We believe delaying the start of deficit reduction would put long-term recovery at risk. Such an approach misjudges politics, financial markets, and underlying economic realities.

Blaming our predicament on financial markets, as some in the second camp do, ignores the awkward truth that governments have enabled, if not enthusiastically promoted, recklessness, through chronic deficits and lax financial regulation. Our predicament, in this sense, is a political crisis at least as much as a financial one. We can’t expect “credibility” by succumbing to temptation just one more time. What politicians like to present as saving the world economy from financial markets is in many cases simply responding to past errors while continuing to operate on a time horizon no longer than the next election.

Count me with the "others" in the "second camp." In the case of the US, there is still little evidence of a problem. If markets were losing their appetite for US government debt, it would be reflected in rising Treasury yields, which are not apparent (unless you read alot into that tick at the end): That's not to say that their concern is irrational. If government finances don't eventually improve, at some point borrowing costs will rise, and crowd out private investment. We're not there yet, but it would make sense to think about what we'll do before we get there.

A couple of things to bear in mind:

  • The government budget will get somewhat better when the economy recovers, and spending cuts or tax increases now would serve to slow the recovery.
  • In the US, the long term federal budget problem is driven by projected increases in health care costs, so the bill just signed by the president is a step in the right direction, to the extent it helps control cost growth.
Sachs and Osborne seem to think that any policy would not be "credible" - i.e., would not influence expectations about future borrowing - if it does not inflict some pain today. They may be right, but I don't think so. If enacted today, a tax reform that projected to yield revenues closer to spending at "full employment" (i.e., once cyclical effects are taken out) would be a significant step to pre-empting the problem, even if the current deficit remains large because of the downturn. This would be true even if the reforms were phased in or scheduled to take effect in a few years. Indeed, some of the tax changes could be written to be contingent on recovery. But, while we should take future deficits seriously, we should not lose sight of the fact that, right now, a large deficit is exactly what we need to help make up the shortfall in private demand.

At Economist's View, Mark Thoma has a similar opinion to mine.

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