Fiscal austerity or economic growth?

Although it’s not officially on the agenda, that question will dominate the discussions this weekend as political leaders of the world’s largest economies assemble at Camp David.

And that same question — how, how much and how quickly to cut the federal budget deficit — remains the central issue in this year’s U.S. presidential and congressional elections.

This is hardly a new debate; it’s been going on ever since John Maynard Keynes and Friedrich von Hayek sent dueling letters to the Times of London at the onset of the Great Depression. But it has lately taken on new urgency as attempts to rein in government budget deficits in Europe have sparked a backlash from voters, sent much of the continent back into recession and threatened the future of the euro.

The argument for belt-tightening austerity is that government debt in many countries has climbed so high that it threatens to create a vicious spiral: Higher interest rates beget recessions, which in turn lower government tax revenues and lead lenders to demand even higher interest rates. The inevitable result is default and depression.

The rapid rise of interest rates for the bonds of Greece, Ireland, Portugal, Spain and Italy a year ago raised the specter of just such a debt spiral. European leaders responded by committing themselves to immediate and dramatic reduction in deficit levels. Similar fears have energized debt-cutting fervor in the United States.

Where the problem comes in is that too much austerity imposed too quickly risks causing another, similar downward spiral. In this deflationary spiral, overly aggressive tax increases and budget cuts lead to sharp increases in unemployment and decreases in spending and investment, causing tax revenues to fall so much that budget deficits actually go up. That’s certainly what has happened in Greece, Ireland and Portugal, and to a lesser degree in a number of other countries, including our own.

Given this choice between default and deep recession, what’s a highly indebted country to do? As Olivier Blanchard, the chief economist at the International Monetary Fund, observed, there is a “damned if you do, damned if you don’t” quality to the austerity debate, one that is often overlooked by dogmatic Keynesians who argue reflexively that the right course is always to borrow and spend to stimulate growth, and Keynesian skeptics who are equally reflexive in arguing that any positive effects of fiscal stimulus are more than offset by a loss of confidence by investors and business owners.

In truth, austerity vs. growth is a false choice. The right answer depends on the economic particulars — the relative efficiency of a country’s economy, the mood of the markets, what’s going on in other countries at that moment in time. It also depends on the particulars of the austerity or the stimulus — what spending is increased or decreased, what taxes are raised or lowered. Also important are what structural reforms are put in place to accompany the austerity or the stimulus.

In countries such as Greece, Spain, Portugal and Italy — Europe’s profligate and uncompetitive southern tier — debt levels and interest rates on government bonds are so high that a debt spiral is a real concern. There is no way these countries can borrow and spend their way out of the holes they’re now in. So the right policy needs to start with reducing the government’s structural budget deficit — the deficit that would exist even when the economy is at full employment.

In those countries, that would involve sizeable cuts in government employment and the money the government doles out in the form of pensions, social benefits and business subsidies. In most of those countries, it would also involve stepped-up enforcement of tax laws that are now widely evaded. The inevitable short-term effect: fewer jobs, lower incomes, less consumption.

Austerity alone is not enough, however. At the same time, those countries — either individually or through the European Union’s new stabilization fund — need to be borrowing and spending for other purposes.

The first would be to recapitalize their troubled banks so that they could resume active lending to private businesses. To varying degrees, that is already going on, but the pace has been too slow and the amounts too timid, as bankers and regulators hope against hope that bad loans will magically turn good again. Experience shows that delaying just makes things worse.

At the same time, the stronger economies of Europe — Germany, the Netherlands — need to drop their fixation with their own belt-tightening and start spending and investing in ways that stimulate growth not only within their borders but throughout the continent. This could take the form of tax cuts to stimulate imports of consumer goods. Or it could take the form of public investments in infrastructure projects that will provide a decent return to German and Dutch taxpayers while also enhancing long-run productivity in the troubled economies.

None of this, however, will be sufficient unless it is accompanied by a renewed inflow of private investment, which will happen only with major reforms of labor and product markets that are now uncompetitive as a result of excessive regulation. These reforms could have the short-run effect of increasing unemployment and reducing the incomes of some workers. But without them, pouring in all that public investment will be akin to pouring water into a leaky bucket.

Meanwhile, in France, the new Socialist president has been swept into office on promises to trade in a policy of austerity for one of growth. Francois Hollande can make a plausible case that France has the economic and financial headroom to put off deep budget cuts for a few years more. But Hollande’s promises of growth are undermined by a determination to raise taxes on businesses and investors while rolling back even some of the modest reforms to labor and product markets pushed through by his predecessor. In a country where government accounts for a whopping 56 percent of the economy, the only recipe for growth is lower taxes, smaller government and a more open and competitive private sector.

Britain poses a somewhat different challenge, if for no other reason than it is a relatively competitive economy, still has its own currency and is still considered a safe haven for bondholders, despite debt and deficit levels that are quite high. Prime Minister David Cameron has embarked on an ambitious austerity policy, only to see the economy dip back into recession. Given that interest rates on U.K. bonds remain manageable, the wiser course now would be to delay the implementation of tax hikes and spending cuts that create the most short-term drag on the economy while pushing ahead with reforms, such as restructuring of the health-care system, that will have a bigger long-term impact on the budget and the competitiveness of the British economy. Unfortunately, the politically wounded Cameron seems inclined to push ahead with the former while ignoring the latter.

And what of the United States? Despite near-record deficits and a seemingly dysfunctional budget process, the Treasury continues to borrow record amounts of money at record-low interest rates, largely on the underlying strength of the U.S. economy. Obviously, the current level of deficit spending can’t continue forever. But the markets seem willing to tolerate a few more years of it if we are able to avoid a repeat of last year’s debt-ceiling debacle and finally put a credible long-term deficit reduction plan in place.

The lesson here is a pretty simple one: To avoid ending up like Greece, stop acting like Greece.

For previous columns by Steven Pearlstein, see