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Cutting back is not the answer

At first, most developed economies responded to the global financial crisis in 2008 and '09 with stimulus. They increased government spending and cut taxes. John Maynard Keynes provided the playbook: In slack times, the government needs to fill in for diminished private demand.

But 2010 is shaping up to be a year of parsimony. To win support for an international bailout, Greece enacted a tough package of budget cuts and tax increases. Spain's left-wing government at the end of May slashed civil-servant pay by 5 percent and froze pensions — even though one in five Spaniards is out of work. German Chancellor Angela Merkel unveiled a $144 billion package that would raise taxes on airline flights and cut defense spending and public works. "We can't have everything we want if we are to shape the future," Merkel said.

In the United States, even though unemployment remains high, the House scaled back a proposed jobs bill out of concern for the deficit. President Barack Obama called for federal agencies to identify cuts of up to 5 percent in 2012. States and cities are slashing budgets and raising taxes. Worldwide, what New York Times columnist Paul Krugman has called "the pain caucus" is in the ascendancy.

Countries are joining the caucus for different reasons. Many, especially slow-growing, highly indebted countries in southern Europe, see austerity as a way to avoid the fate of Greece. Others are reacting to fears of stimulus-induced inflation. In fact, signs of inflation are scarce.

"To say that we need policies now to fight a global outbreak of inflation is like arguing that we need policies now to guard against the imminent alarming spread of the North Polar ice cap," says University of California-Berkeley economist Brad DeLong. Yet important economies remain hypersensitive to the merest trace of inflation. Germany is taking tough steps because it wants to set an example for the European monetary union, but also because it is paralyzed by the ghost of the 1920s' hyperinflation, which paved the way for Hitler.

In the United States, the same internal debate that roiled the Clinton White House in 1993 — when advisers Robert Rubin and Robert Reich tangled over the relative merits of deficit reduction and stimulus — is being replayed. In 1993 the Rubinites won, arguing that Democrats needed to demonstrate a commitment to deficit reduction to avoid being tarred as tax-and-spenders.

The Obama administration has made a different calculation: Higher short-term deficits are a greater political risk than slower growth and higher unemployment. But the debate fails to recognize the anti-stimulus provided by states and cities, which are prohibited from running deficits. The Center on Budget and Policy Priorities calculated that 33 states made tax changes in 2008 or '09 that would increase annual revenues by $31.7 billion. Meanwhile, state and local governments slashed 22,000 jobs in May. "The actions that states are taking because of the recession and their balanced-budget requirements are slowing the economy," said Nicholas Johnson, director of the state fiscal project at CBPP.

It's difficult to contract your way to growth. The world's large economies need to run higher deficits in the short term to promote growth and close the gaps later. St. Augustine famously pleaded: "Grant me chastity and continence, but not yet." Policymakers might rethink Augustine. Give us austerity and deficit reduction — but not yet.

Cutting back is not the answer 06/19/10 [Last modified: Friday, June 18, 2010 5:24pm]
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