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Treasury Notes

 Why Now’s Not the Time to Withdraw Support for the Economy

By: Dr. Jan Eberly
12/5/2011

Last week Congress missed an opportunity to support economic growth and job creation by failing to pass President Obama's proposal to extend and expand the employee-side payroll tax cut, cut payroll taxes in half for every small business, and eliminate payroll taxes on increases in business payrolls.

If Congress does not pass measures that support the economy by the end of this year, fiscal policy is expected to be a substantial drag on growth in 2012, as the payroll tax and extension of unemployment insurance benefits put in place last December expire and support from the Recovery Act continues to recede.  Private forecasters estimate that these factors will subtract between 1 and 2 percentage points from GDP growth in 2012.  The impact on growth in the first quarter could be even greater.  At this critical juncture, the U.S. economy should not be subjected to such a strong, self-induced headwind.

While there is a nearly complete consensus among economists and budget analysts that deficit reduction sufficient to stabilize our debt would have significant long-run economic benefits, the literature also cautions that fiscal consolidation is contractionary in the short run.  Though under certain conditions the withdrawal of fiscal support can be partially offset by economic and policy changes, those conditions do not prevail in the United States today.  Interest rates are currently at historic lows, leaving little room for them to go lower, and though exports have grown at a healthy pace recently, they cannot be counted on to grow enough to offset substantial near-term cuts.

The economy is improving at a gradual pace.  That said, the recovery is far from complete, the unemployment rate remains unacceptably high, and we face significant downside risks to growth.  Throughout history, a common mistake in the wake of financial crises is to withdraw support too soon.  Even simply extending the existing payroll tax holiday and emergency unemployment insurance program will merely keep us in place.  That is not enough.  Though phased in deficit reduction in the medium term is needed, it must be combined with aggressive support for the economy right now.

Impact of Fiscal Consolidation on Near-Term Growth

While the economy has expanded for nine consecutive quarters, recent growth has not been fast enough to substantially bring down unemployment.  GDP growth picked up from an annual rate of about ¾ percent in the first half of the year to 2 percent in the third quarter, but economic activity last quarter was boosted by the waning of factors that temporarily held down growth earlier in the year, including the jump in oil prices and the reduction in motor vehicle production due to the crisis in Japan.  For 2011 as a whole, growth may very likely be below 2 percent and private forecasters project GDP to rise at about a 2 percent pace through 2012. 

Some politicians have argued that in order to jumpstart growth, the United States needs to make a serious down payment on deficit reduction.  However, fiscal consolidation is typically contractionary in the short run, boosting growth only in the long run.  In a variety of standard economic models, government support boosts output by increasing demand, desired hours of work and the optimal capital stock (see for example the discussion in Ramey, 2011).[1]  However, in the long run, larger deficits result in higher interest rates and dampened output.  A reduction in government support operates similarly, but in the reverse direction, putting a drag on the economy in the short run.  In the U.S. context, the impending withdrawal of fiscal impetus occurs at a time when there is little capacity for other changes in the economy that might offset it.  Meanwhile, we face immediate and significant risks to the already modest growth projections for 2012.

The view that fiscal consolidation is contractionary in the near term is supported by broad empirical research, including a recent study by the IMF that focused on the experiences of 15 advanced economies from 1980 to 2009.  The IMF found that a fiscal consolidation equal to 1 percent of GDP typically reduces GDP by ½ percentage point over the first two years and increases the unemployment rate by ¼ percentage point (Figure 1).  To put this in perspective, the reduction in federal support that would occur if Congress allows the payroll tax holiday and emergency unemployment benefits to expire is roughly equivalent to 1 percent of GDP.

Figure 1.
Impact of a 1 Percent of GDP Fiscal
Consolidation on GDP and Unemployment  



Economic Changes That Can Offset the Effects of Fiscal Consolidation
As the IMF study highlights, the reduction in government support can be offset by a number of factors such as an increase in confidence and a reduction in interest rates, driven by the increase in national saving and reduction in risk that accompanies a decline in the deficit.  The decline in interest rates promotes domestic and external demand, as well as investment, supporting growth to help offset the fiscal consolidation.
 
Figure 2.
Response of Interest Rates to a
1 Percent of GDP Fiscal Consolidation
 
Source: IMF staff calculations.
Note: t = 1 denotes the year of consolidation. Dotted lines equal one standard error bands.
Some commentators with enthusiasm for near-term cuts cite a recent paper by Alberto Alesina and Silvia Ardagna (2010),[2] which argues for a dominant role for these potential mitigating factors.  However, as the IMF has noted, their definition of fiscal consolidation has serious limitations.[3]  For instance, their sample omits the 2009 adjustment instituted in Ireland, which amounted to 4.5 percent of GDP because house prices collapsed that year thus increasing the primary budget deficit.  While it is always tricky to disentangle changes in fiscal policy from the economic environment in which they are conducted, omitting examples like this reduces the applicability of the sample.  In another case, Alesina and Ardagna included an episode that occurred in Japan in which the government made a one-time capital transfer to the railways amounting to 4.8 percent of GDP in 1998 and then in 1999, in the absence of such a transfer, the budget balance improved mechanically without a government spending cut.  This is not a case of fiscal consolidation as we would normally think of it and biases the results in favor of finding expansionary consolidations.  Even with these limitations, the study found that only about 1/5 of fiscal consolidations were in fact expansionary.  This is consistent with the possibility that offsetting factors can potentially lessen the impact of a consolidation as pointed out by the IMF study, but suggests it is an unlikely result.
 
The United States' Ability to Offset Negative Effects of Fiscal Consolidation is Limited
 
Given today's economic realities, the United States is unlikely to benefit from many of the factors that could potentially attenuate the negative impact of a fiscal consolidation.  We already face a large gap between actual and potential GDP, which would be exacerbated by a reduction in fiscal support (Figure 3).
 
Figure 3.
Source: Bureau of Economic Analysis and Treasury calculations.
In addition, much of the potential mitigating effect of fiscal consolidation is driven by lower interest rates. However, the yield on the 10-year Treasury bond is around 2.0 percent, already extraordinarily low by historical standards (Figure 4).  This suggests that any gain in confidence from an improved fiscal outlook is unlikely to translate into still lower interest rates in the near term. 
 
Figure 4.
 
Source: U.S. Treasury
A final way to offset fiscal consolidation would potentially come through a significant increase in exports, allowing for foreign demand for goods and services to fill in the gap left by lower domestic demand.  Since their trough during the financial crisis, exports have grown by 23 percent in real terms and have been a significant part of the economic recovery to date.  However, given the challenges to growth globally, especially in advanced economies that are key trading partners, the United States cannot count on further increases in the demand for our exports from overseas markets to materially offset large-scale fiscal consolidation.
 
Conclusion
 
The United States faces modest growth projections for next year with substantial downside risks and has limited scope to offset the withdrawal of fiscal support. Given these realities, we must act by the end of the year to strengthen growth and job creation in 2012.
 
Dr. Jan Eberly is the Assistant Secretary for Economic Policy.


[1] Ramey, Valerie A. (2011) "Can Government Purchases Stimulate the Economy?" Journal of Economic Literature 49:3, 673-685
[2] Alberto Alesina and Silvia Ardagna, "Large Changes in Fiscal Policy: Taxes Versus Spending," Tax Policy and the Economy, vol. 24, ed. Jeffrey R. Brown (Cambridge, MA: National Bureau of Economic Research). 
[3] "Will It Hurt? Macroeconomic Effects of Fiscal Consolidation". Chapter 3 of the IMF's October 2010 World Economic Outlook.  "Cutting Edge.  Does fiscal austerity boost short-term growth?  A new IMF paper thinks not" The Economist, September 30th 2010.
Posted in:  Economic Policy
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