Opinion

Lawrence Summers

The economics of austerity

Lawrence Summers
Jun 3, 2013 12:45 UTC

Paced by housing and energy, the U.S. recovery is likely to accelerate this year and budget deficit projections have declined as well.  Unfortunately the European economy remains stagnant though there is some evidence that stimulative policies are gaining traction in Japan.  Around the world the idea of “austerity” is fiercely debated.  This all makes a reconsideration of the principles that should guide fiscal policy opportune. This requires recognizing that policies need to be set in light of economic circumstances.

A prudent government must over time seek to balance spending and revenue collection in a way that assures the sustainability of debts. To do otherwise leads to instability and needlessly slow growth and courts default and economic catastrophe. Equally, however, responsible fiscal policy requires recognizing that when economies are weak and movements in interest rates are constrained ‑ as has been the case in much of the industrial world in recent years ‑ changes in fiscal policy will have significant effects on economic activity that in turn will affect revenue collections and social support expenditures. In such circumstances, aggressive efforts to rapidly reduce budget deficits may actually backfire, as a contracting economy offsets any direct benefits.

It is a truism that deficit finance of government activity is not an alternative to tax finance or to supporting one form of spending by cutting back on another. It is only a means of deferring payment for government spending and, of course, because of interest on the debt, increasing the burden on taxpayers. A household or business cannot indefinitely increase its debt relative to its income without becoming insolvent, and neither can a government. There is no viable permanent option of spending without raising commensurate revenue.

It follows that in normal times there is no advantage to deficit policies. Public borrowing does not reduce ultimate tax burdens. It tends to crowd out private borrowing to finance growth and job-creating investment and foster international borrowing, which means an excess of imports over exports. Or the expectation of future tax increases may discourage private spending. While government spending or tax cutting financed by borrowing creates increased demand in the economy, the Federal Reserve can in normal times achieve this objective by adjusting base interest rates.

It was essentially this logic that drove the measures taken in the late 1980s and in the 1990s, usually on a bipartisan basis, to balance the budget. As a consequence of policy steps taken in 1990, 1993 and 1997, it was possible by the year 2000 for the Treasury to use surplus revenue 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 the unemployment rate fell below 4 percent. Essentially, 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, which reinforced the cycle.

The lessons of Reinhart-Rogoff

Lawrence Summers
May 6, 2013 13:38 UTC

The economics commentariat and no small part of the political debate in recent weeks has been consumed with the controversy surrounding the work of my Harvard colleagues (and friends) Carmen Reinhart and Ken Rogoff (RR). Their work had been widely interpreted as establishing that economic growth was likely to stagnate in a country once its government debt-to-GDP ratio exceeded 90 percent. Scholars at the University of Massachusetts have demonstrated and RR have acknowledged that they made a coding error that resulted in their omitting some relevant data in forming their results and also have noted that using updated data for several countries reduces substantially the strength of some of the statistical patterns they asserted. Issues have also arisen with respect to how RR weighted observations in forming the averages on which they base their conclusions.

Many have said that the questions raised undermine the claims of austerity advocates around the world that deficits should be quickly reduced. Some have gone so far as to blame RR for the unemployment of millions, asserting that they provided crucial intellectual ammunition for austerity policies. Others believe that even after re-analysis the data support the view that deficit and debt burden reduction is important in most of the industrialized world. Still others regard the controversy as calling into question the usefulness of statistical research on economic policy questions.

Where should these debates settle? From the perspective of someone who has done a fair amount of econometric research, consumed such research as a policymaker and participated as an advocate in debates about fiscal stimulus and austerity, here would be my takeaways.

Job #1 for the IMF: Stay the course and avoid lurches to austerity

Lawrence Summers
Oct 15, 2012 03:57 UTC

If the global economy was in trouble before the annual World Bank and IMF meetings in Tokyo this past weekend, it is hard to believe that it is now smooth sailing. Indeed, apart from the modest stimulus provided to the Japanese economy by all the official visitors to Tokyo, it’s not easy to see what of immediate value was accomplished.

The U.S. still peers over a fiscal cliff, Europe staggers forward preventing crises King Canute-style with fingers in the dyke but no compelling growth strategy, and Japan remains stagnant and content if it can grow at all. Meanwhile, each BRIC is an unhappy story in its own way, with financial imbalances impeding growth in the short run and deep problems of corruption and demography casting doubt on long-run prospects.

In much of the industrial world, what started as a financial problem is becoming a deep structural problem. If growth in the United States and Europe had been maintained at its average rate from 1990 to 2007, GDP would be between 10 and 15 percent higher today and more than 15 percent higher by 2015 on realistic projections. Of course this calculation may be misleading because global GDP in 2007 was inflated by the same factors that created financial bubbles.  Yet even if GDP was artificially inflated by 5 percentage points in 2007, output is still about $1 trillion short of what could have been expected in the U.S. and EU.  This works out to more than $12,000 for the average family.

Why the UK must reverse its economic course

Lawrence Summers
Sep 17, 2012 11:32 UTC

It is the mark of science and perhaps rational thought more generally to operate with a falsifiable understanding of how the world operates. And so it is fair to ask of the economists a fundamental question: What could happen going forward that would cause you to substantially revise your views of how the economy operates and to acknowledge that the model you had been using was substantially flawed? As a vigorous advocate of fiscal expansion as an appropriate response to a major economic slump in an economy with zero or near-zero interest rates, I have for the last several years suggested that if the British economy – with its major attempts at fiscal consolidation – were to enjoy a rapid recovery, it would force me to substantially revise my views about fiscal policy and the workings of the macroeconomy more generally.

Unfortunately for the British economy, nothing in the record of the last several years compels me to revise my views. British economic growth post-crisis has lagged substantially behind U.S. growth, and the gap is growing. British GDP has not yet returned to its pre-crisis level and is more than 10 percent below what would have been predicted on the basis of the pre-crisis trend. The cumulative output loss from this British downturn in its first five years exceeds even that experienced during the Depression of the 1930s. And forecasts continue to be revised downward, with a decade or more of Japan-style stagnation now emerging as a real possibility on the current course.

Whenever policy is failing to achieve its objectives, as in Britain today with respect to economic growth, there is a debate as to whether the right response is doubling down – perseverance and intensification of the existing path – or recognition of error or changed circumstances and a change in course. In Britain today such a debate rages with respect to the aggressive fiscal consolidation that the government has made the centerpiece of its economic strategy.  Until and unless there is a substantial reversal of course with respect to near-term fiscal consolidation, Britain’s short- and long-run economic performance is likely to deteriorate.

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