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Simon Johnson on the Extraordinary Unlikelihood of an Expansionary Fiscal Contraction in the United States

Simon Johnson:

Could The US Have An “Expansionary Fiscal Contraction?: There are four conditions under which fiscal contractions can be expansionary.  But none of these conditions are likely to apply in the United States today. 

First, if there is high perceived sovereign default risk, fiscal contraction can potentially lower long-term interest rates.  But the US is currently one the lowest perceived risk countries in the world – hence the widespread use of the US dollar as a reserve asset.  To the extent there is pressure on long-term interest rates in the US today due to fiscal concerns, these are mostly about the longer-term issues involving healthcare spending; if this spending were to be credibly constrained (e.g., in plausible projections for 2030 or 2050), long rates should fall.   In contrast, cutting discretionary spending, which is a relatively small part of the federal budget, would have little impact on the market assessment of our longer-term fiscal stability. 

Second, it is also highly unlikely that short-term spending cuts would directly boost confidence among households or firms in the current US situation, particularly with employment still around 5 percent below its pre-crisis level.  The US still has a significant “output gap” between actual and potential GDP, so unemployment is significantly above the achievable rate.  Fiscal contractions rarely inspire confidence in such a situation.

Third, if monetary policy becomes more expansionary while fiscal policy contracts, this can offset to some degree the negative short-run effects of spending cuts on the economy.  But in the US today, short-term interest rates are as low as they can be and the Federal Reserve has already engaged in a substantial amount of “quantitative easing” to bring down interest rates on longer-term debt.  It is unclear that much more monetary policy expansion would be advisable or possible in the view of the Fed, even if unemployment increases again – for example because fiscal contraction involves laying off government workers.

Fourth, tighter fiscal policy and easier monetary policy can, in small open economies with flexible exchange rates, push down (depreciate) the relative value of the currency – thus increasing exports and making it easier for domestic producers to compete against imports.  But this is unlikely to happen in the United States, in part because other industrialized countries are also undertaking fiscal policy contraction.  Also, the preeminent reserve currency status of the dollar means that it rises and falls in response to world events outside our control – and at present political and economic instabilities elsewhere seem likely to keep the dollar relatively strong.

The available evidence, including international experience, suggests it is very unlikely that the United States could experience an “expansionary fiscal contraction” as a result of short-term cuts in discretionary domestic federal government spending...