July 11, 2016

Reduce the Debt to G.D.P. Ratio

Veronique de Rugy

Senior Research Fellow
Summary

Fiscal adjustments based on spending cuts signal that a country is serious about getting its house in order. More taxing and spending do not.

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Recessions are a part of the natural economic cycle — they ease economic disequilibria, often exacerbated by bad policies.

Politicians, and the technocrats who advise them, should recognize that they can’t completely stop recessions. Many of the policies aimed at moderating recessions can lead to excesses in the economy that make later recessions far worse.

The 1998 bailout of the small hedge fund Long-Term Capital, for example, set a terrible regulatory precedent of ad hoc government support for financial institutions. It's possible that inaction by the Fed and Treasury at that time would have caused a small recession if Long-Term Capital was left to fail, but it would have been better to weather it then — when there was a budget surplus and no collapsed housing bubble. Plus it would have sent a message to financial institutions to curb their recklessness.

Still, there are things that can be done to help us weather the next downturn better than we have in the past:

First, the more flexibility there is in terms of prices, wages, employment and the ability to start or dissolve businesses, the better the economy is at being able to weather sudden reductions in spending and investment. Minimum wage and other labor laws, for example, may make is impossible to hire workers at lower wages during a recession.

Second, the uncertainty the government injects in the economy plays a major role in the length and severity of recessions. For instance, massive regulations, such as Dodd-Frank, take years to implement and can exacerbate a crisis.

Meanwhile, the discretionary and ad hoc interventions of the Fed and other central banks in the economy doesn't establish firm regulation or precedents. If the government adopted credible, rules to determine when they increase or decrease the supply of money, it would send a clear signal of expectations, which would reduce uncertainty and weaken the risk of recessions.

Last but not least, the government must reduce our debt-to-G.D.P. ratio. Rising debt and slowing G.D.P. is a bad combination. The answer, here, is probably spending cuts. Fiscal adjustment packages made mostly of spending cuts are more likely than tax increases to lead to lasting debt reduction.

This makes intuitive sense: Fiscal adjustments based on spending cuts signal that a country is serious about getting its house in order. More taxing and spending do not.