America's Sensible Stance on Recovery

Economic commentators are mired in an unhelpful dialectic between "jobs" and "deficits" that, despite its apparent simplicity, has obscured rather than clarified the policy choices ahead in the US, Europe and elsewhere.

Critics have complained that the continued commitment by the administration of President Barack Obama to support recovery in the short term and also to reduce deficits in the medium and long term constitutes a "mixed message". In fact, it is the only sensible course in an economy facing the twin challenges of an immediate shortage of demand and a fiscal path in need of correction to become sustainable.

Most economists across a broad spectrum would likely agree to three basic propositions about fiscal policy.

First, in normal times, the scale of government budget deficits affects the composition but not the level of output. Increased deficits under these conditions will raise either public spending or private consumption. But because interest rates adjust upward to balance supply and demand at full employment or at the central bank's desired level of output, any increases in these sources of demand will be offset by reduced investment and net exports. As a consequence, budget deficits will not stimulate output or employment,

A range of other considerations - including the crowding out of investment; reliance on foreign creditors; misallocation of resources into inefficient public projects; and reduced confidence in long-run profitability of investments - all make a case in normal times for fiscal prudence and reduced budget deficits.

And there are numerous examples, notably the US in the 1990s, where reducing budget deficits contributed to enhanced economic performance.

Second, where an economy's level of output is constrained by demand and the central bank has at best a limited ability to relax that constraint because it cannot reduce interest rates to below zero, fiscal policy can have a significant impact on output and employment. Through either direct spending or tax cuts that promote private spending, hiring or investment, governments possess a range of tools to raise demand directly. As increased demand boosts incomes, these measures raise output further. The result will be economic growth and reduced joblessness.

To the extent that expansionary fiscal policies affect growth, their impact on future indebtedness is attenuated as tax collections rise, transfer payments fall, and the ability of the economy to support debt increases.

Third, and finally, there is a very strong presumption that there are likely to be beneficial effects from the expectation that budget deficits will be reduced after an economy has recovered and is no longer demand-constrained. Not least of these are increased confidence and reduced capital costs that encourage investment, even before the deficit is reduced. Such impacts are likely to be particularly important when prospective deficits are large and raise substantial questions about sustainability or even creditworthiness.

In most of the industrialised world, given that economies are in or near liquidity trap conditions, it is the last two propositions that should control policy. Together they make a case for fiscal actions that maintain or increase demand in the short run while reassuring markets on sustainability over the medium term.

Mr Obama is building on the Recovery Act - passed early last year and now in its most intense phase of public investment - by fighting to extend unemployment and health benefits to those out of work, and to help struggling state and local governments prevent cutbacks in vital services and avoid job losses for teachers, police officers and firefighters. At the same time, he is pushing for additional measures to help create and protect jobs, and strengthen businesses. He has called on Congress to expand the clean energy manufacturing tax credit, to help small businesses through tax cuts and a lending fund, and to pass his proposal to create jobs while upgrading energy efficiency in homes.

While the first step in any sound fiscal strategy must be to do everything we can to promote recovery, Mr Obama has also made it a priority to take tough steps to bring down the deficit to sustainable levels as recovery is achieved.

Fiscal responsibility is not only about our children and grandchildren. Excessive budget deficits, left unattended, risk weakening our markets and sapping our economic vitality. They raise the question - as when Washington put off hard choices during much of the previous decade - of how long the world's greatest borrower can remain its greatest power.

During the next five years, the US is expected to experience the fastest deficit reduction since the second world war. Much of that will stem from the return to growth and the phasing out of Recovery Act programmes.

But Mr Obama has made other commitments that further reduce the deficit by more than $1,000bn. They include a three-year freeze on discretionary spending outside national security and allowing the 2001-03 tax cuts to expire for the very richest. He has also put in place a framework that offers the potential to contain health costs, and convened a

bipartisan commission that will make recommendations to cover the costs of all federal programmes by 2015 and improve the long-run fiscal outlook.

The combination of measures that prevent sharp declines in demand in the short run, and measures that add to confidence by controlling the factors that drive deficits, offers the best prospect for moving the economy forward in the next few years. Of course, US growth can come only in a global context. That is why Mr Obama welcomed the Group of 20 leading nations' emphasis last month on the importance of global actions to ensure that sound fiscal policies are in place and also that economic recovery has sufficient momentum.

We will see clearly in the years ahead that pushing growth and reducing deficits are complementary, not competing, objectives. Reducing the spectre of prospective deficits will enhance near-term growth. And ensuring adequate growth in the near term will reduce long-term deficits.

The writer is President Barack Obama's chief economic adviser and director of the White House National Economic Council