Why Now’s Not the Time to Withdraw Support for the Economy: 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… subtract between 1 and 2 percentage points from GDP growth in 2012…. At this critical juncture, the U.S. economy should not be subjected to such a strong, self-induced headwind….
[T]he 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….
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… 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…. [R]eduction 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….
Some commentators with enthusiasm for near-term cuts cite a recent paper by Alberto Alesina and Silvia Ardagna (2010)…. However, as the IMF has noted, their definition of fiscal consolidation has serious limitations…. 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…. 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….
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….
[M]uch 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… any gain in confidence from an improved fiscal outlook is unlikely to translate into still lower interest rates in the near term.
A final way to offset fiscal consolidation would potentially come through a significant increase in exports…. 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…