Davos and Deficits: A Question of Timing

Economists at Davos diverged over whether it's better to slash budgets like Britain's David Cameron or hedge on the deficit like Barack Obama

High in the Swiss Alps, executives and economists lined up to warn President Barack Obama that he must be more ambitious in cutting a fiscal shortfall the Congressional Budget Office now estimates will reach $1.5 trillion this year. By contrast, British Prime Minister David Cameron was pushed by delegates including billionaire George Soros to rethink Britain's tightest fiscal squeeze since World War II before it triggers another recession. "The timing of austerity was the one theme at Davos where there was a lot of disagreement," says Nariman Behravesh, chief economist at consultancy IHS Global Insight.

No policymaker likes the options: Go too fast in paring spending or raising taxes, and a government risks snuffing out an expansion that has only just begun and is still not powerful enough to propel hiring. Act too slowly, and investors may start imposing higher interest rates, hurting growth in another way. "You've got to strike the right balance, and it's not going to be easy," says Canadian Finance Minister James M. Flaherty.

The fiscal debate is moving to center stage just as the International Monetary Fund has upgraded its forecast for global growth to 4.4 percent this year, from its earlier estimate of 4.2 percent. As the outlook has improved, some economists at Davos argued that Obama's fresh budget savings of almost $500 billion, revealed in his State of the Union address, were too meager. They said that after signing an $858 billion tax cut, Obama had to take advantage of the rebound and cut spending further. "Unless the U.S. addresses this fiscal problem, we're going to have a train wreck," says Nouriel Roubini, chairman of Roubini Global Economics. James S. Turley, chief executive officer of Ernst & Young, says "we need a heck of a lot more action" in the U.S.

Cameron's strategy didn't fare much better at Davos. Soros says Cameron's austerity budget cannot "possibly be implemented without pushing the economy into a recession." (The British economy shrank unexpectedly by 0.5 percent in the final quarter of 2010, even before Cameron's cuts were felt.)

Cameron used a keynote speech to restate that his "first priority is to kill off the specter of massive sovereign debts." After exchanging places with him on the stage, U.S. Treasury Secretary Timothy F. Geithner said U.S. growth is still too weak to push unemployment down significantly. He added that while it's right to balance the budget over the longer run, quick and premature cuts aren't "responsible" and risk doing "a lot of damage to an early expansion."

Nobel Laureate Joseph Stiglitz backed the U.S. bias toward sustained stimulus and warned Cameron he "is succeeding in causing a recession" that may end up inflicting more debt on the country as tax receipts fall and welfare spending rises. Harvard's Niall Ferguson, an informal adviser to Cameron, says the "U.K. is doing the right thing, and the U.S. has made no attempt whatsoever to deal with this issue. If Japan can get downgraded, why can't the U.S.?" he asks. (Standard & Poor's (MHP) recently downgraded Japanese sovereign debt.) Raghuram G. Rajan, a former IMF chief economist and a professor of finance at University of Chicago's Booth School of Business, uttered the ultimate truth: "There is no painless deficit reduction."

The bottom line: Davos exposed a rift in economists' ranks over which is better: Obama's softly-softly approach to the deficit, or Cameron's ax.