Timing Is Everything: Fiscal Jolt Can Lower Debt in Recessions

  • Jackson Hole paper urges lawmakers not to balk over debt
  • Long-term debt levels need attention, but not during downturns

Lawmakers shouldn’t let a high national debt discourage them from pumping up fiscal spending when the next recession hits, according to new research by two economists at the University of California at Berkeley.

“Expansionary fiscal policies adopted when the economy is weak may not only stimulate output but also reduce debt-to-GDP ratios,” Alan J. Auerbach and Yuriy Gorodnichenko wrote in a paper they’ll present Saturday at the Federal Reserve Bank of Kansas City’s annual symposium in Jackson Hole, Wyoming.

Alan Auerbach in Jackson Hole on Aug. 25.

Photographer: David Paul Morris/Bloomberg

The findings will add to debate over how Congress should respond if the U.S., as expected, tumble into another downturn before the Federal Reserve has had time to lift interest rates to historically normal levels of 4 percent to 5 percent. With its benchmark rate just above 1 percent, the Fed has little room to cut in the next recession, and it may face objections from some Republicans in Congress if it turns again to bond purchases to depress long-term borrowing rates.

That puts the burden on lawmakers to respond with emergency government spending to soften the blow. But some may balk, the authors note, when they consider that debt-to-GDP already lies at 77 percent for the U.S.

That would be a mistake, they argue.

“A fiscal stimulus in a weak economy may help improve fiscal sustainability along the metrics we study,” they write. “There is evidence that this effect is undercut when the debt-to-GDP ratio is elevated, although the penalty for a high debt-to-GDP ratio does not appear to be high at the debt levels experienced historically for developed countries.”

The paper bolsters work by former Treasury Secretary Laurence Summers and another U.C. Berkeley professor, J. Bradford DeLong, who’ve argued that fiscal injections during a recession won’t raise debt-to-GDP levels.

The research also examined the likely impact of fiscal stimulus on short-term borrowing costs for governments. While the series of data they examined doesn’t go back far enough for a firm conclusion, they wrote, it does suggest that emergency spending in a downturn could reduce borrowing costs and narrow credit-default swap spreads between countries.

“This result suggests that markets may view fiscal stimulus as a way not only to accelerate the economy but also to reduce risks associated with a prolonged slump,” Auerbach and Gorodnichenko wrote. “These results suggest that effects on fiscal sustainability through the cost of government borrowing may be not particularly important.”

The authors cautioned that, independent of government action during recessions, developed countries face worrying long-term debt levels related to aging populations and accelerating health care costs. They estimated that by 2050, the U.S. will have to reduce non-interest spending by 9 percent of GDP if it hopes to maintain the current level of debt-to-GDP.

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