Lawrence Summers is a professor and past president at Harvard. He was Treasury secretary from 1999 to 2001 and economic adviser to President Obama from 2009 through 2010.
Around the world the idea of “austerity” is fiercely debated. The various strengths and weaknesses of the global economy make opportune a reconsideration of the principles that should guide fiscal policy: Paced by housing and energy, the U.S. recovery is likely to accelerate this year, and budget deficit projections have declined as well; meanwhile, the European economy remains stagnant, though there is evidence that stimulative policies are gaining traction in Japan. It is critical that policies be set in light of economic circumstances.
A prudent government must balance spending and revenue collection in a way that assures the sustainability of its debts. To do otherwise leads to instability and slow growth; it courts default and catastrophe. Yet responsible governing also requires recognizing that when economies are weak and interest rates are constrained, changes in fiscal policy will have large effects on economic activity. In turn, this activity will improve revenue collection and reduce expenditures on social welfare. In such circumstances, efforts to rapidly reduce budget deficits may backfire.
Yet deficit financing of government activity is not a sustainable alternative to increasing revenue or cutting public spending. It is only a means of deferring payment. Just as a household or business cannot indefinitely increase its debt relative to its income without becoming insolvent, neither can a government. There is no permanent option of public spending without raising commensurate revenue.
In normal times, there is no advantage to running large deficits. Public borrowing does not reduce ultimate tax burdens. It tends to crowd out borrowing by the private sector, which could otherwise finance growth, and fosters international borrowing, which means an excess of imports over exports. The private sector may also be discouraged from spending if businesses fear tax increases to pay for the deficit. In normal times, it is the job of the Federal Reserve to increase demand in the economy by adjusting base interest rates, rather than the job of those in charge of deficit financing.
It was essentially this logic that drove the measures — usually bipartisan — taken in the late 1980s and the 1990s to balance the budget. As a consequence of policy steps in 1990, 1993 and 1997, it was possible by 2000 for the Treasury to retire federal debt. Deficit reduction and the associated reduction in capital costs and increase in investment were important contributors to the nation’s strong economic performance during the 1990s, when productivity growth soared and unemployment fell below 4 percent. We enjoyed a virtuous circle in which reduced deficits led to lower capital costs and increased confidence, which led to more rapid growth, which further reduced deficits.
In recent years, of course, circumstances have been anything but normal. High unemployment, few job vacancies and deflationary pressures all indicate that output is not constrained by what the economy is capable of producing but by the level of demand. With base interest rates at or close to zero, the efficacy of monetary policy has been circumscribed.
Under such circumstances, there is every reason to expect that changes in deficit policies will have direct effects on employment and output in ways that are not normally the case. Borrowing to support government or private-sector spending raises demand, increasing output and employment above levels they otherwise would have reached. But these gains will not be offset by reduced private spending because, unlike in normal times, there is substantial excess capacity in the economy. These “multiplier effects” operate far more strongly during economic downturns sparked by financial crises.
In a paper last spring, economist Brad Delong and I estimated that the effect of contractionary fiscal policies might actually increase debt burdens because of their negative economic impacts. (These estimates, however, remain the subject of substantial debate among other economists.)
What follows from this analysis of the impact of fiscal policy? First, the United States and other countries will not benefit from further measures directed at rapid deficit reduction. Output and jobs will suffer. A weaker economy means that our children may inherit an economy with more debt and less capacity to bear the burden it imposes. Already, premature deficit reduction has affected economic performance in Britain and several countries that use the euro.
Second, while continued deficits are a necessary economic expedient, they are not a viable permanent strategy, and measures that reduce future deficits can increase confidence. This could involve commitments to reduce spending or raise revenue. But there is a better way. Pulling forward necessary future expenditures, such as those to replenish military supplies, repair infrastructure or rehabilitate government facilities, both reduces future budget burdens and increases demand today. It is the right way forward, but getting there will require moving beyond the slogans either in support of or opposition to austerity and focusing instead on what measures can best support sustained economic growth.