Comparing Two Approaches Toward Deficit Reduction

In response to my point that severe austerity is a difficult, costly, and largely counterproductive way to solve a government deficit problem during a time of economic weakness, several readers have asked me what the alternative is. In a word, it's patience.

Economic growth is the single best cure for budget deficits. When the economy does well, tax revenues rise and the deficit falls. A major cause of the budget deficit in the US is the economic downturn. (The other principal culprit is the tax cuts of 2001 and 2003.) And as the economy recovers, the deficit will fall substantially on its own accord, just as it did during the recoveries of the 1980s and 1990s.

To illustrate my point, let's go back to Austerityland. Recall that GDP in Austerityland was $100/year and the budget deficit was $10/year, or an unacceptably high 10% of GDP. Let's also assume an initial debt/GDP ratio of 60%. Suppose that the Austerity Party proposes addressing the budget deficit problem by cutting $5 from government spending in their first year in office and another $5 in their second year in office. (They incorrectly believe that cutting $10 over two years will be sufficient to erase the $10/yr budget deficit.)

Now suppose that there is a rival party: the Growth Party. (Maybe we could call them "The G Party"?) They propose addressing the budget deficit problem through patience. Let the economy grow, they argue, and skip the sharp austerity measures. Instead, just keep government spending constant for a few years, so that spending is gradually brought more in line with tax revenues but a sharp fiscal contraction is avoided.

The results of these two approaches for addressing the country's deficit and debt problem may surprise you. Making a few reasonable assumptions (which are specified below, for those of you who are interested), we can compare the effects of these two alternatives on real GDP and on the debt/GDP ratio. The results are summarized in the chart below.


At the end of the fifth year, the country will still be running budget deficits under either approach (though they'll be somewhat smaller under the austerity program). It will also have a roughly similar amount of debt under either scenario, at approximately 75% of GDP. But the path the country followed to get there will be very different depending on which policy they pursued.

Under the austerity program, the country will have experienced a sharp recession (and possibly deflation), so that by the fifth year the average family will still have less real income than they did before the austerity program. Under the growth program, on the other hand, income will have increased steadily, so that after five years the average family's annual income will be almost 20% higher in real terms than under the austerity program -- while the government's debt burden is no greater. (Of course in year 6 the government may decide to change its policies under either scenario.)

Given this choice, which policy would you vote for?

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Note that this exercise assumes the following:
1. The tax rate is 25% and fiscal multiplier is 1.5.
2. The real (i.e. inflation-adjusted) interest rate on government borrowing is 2.0%.
3. The inflation rate averages 0% per year under the austerity scenario and 2.0% per year under the patience scenario.
4. The economy experiences a real growth rate of 3.0% per year in both scenarios (not including the effects of fiscal policy).