Back to the macroeconomic ’90s? Lower deficits can again create more growth

Washington’s reliance on deficit spending is a rare bipartisan habit, but it’s unlikely to change, whatever the outcome of the November elections: There is a strong belief on both sides of the political divide that fiscal consolidation, whether through spending cuts or tax hikes, reduces growth.

But what this political consensus misses are the circumstances in which the classic trade-off is suspended—the circumstances in which smaller deficits might, counterintuitively, lead to more growth. Today’s macroeconomic environment is ideal for such an approach.

Compared to pre-pandemic years, fiscal policy (government spending and taxation) continues to step on the gas, and deficits remain large, especially given the health of the economy. At the same time, monetary policy by the Federal Reserve continues to step on the brakes, slowing the economy and suppressing inflation.

This is a wasteful combination of economic policy: costly growth fueled by expanding deficits is being offset by tight monetary policy that seeks to curb that same growth. The least costly (and less risky) way to slow the economy is to take your foot off the gas.

Skeptics of “debt reduction stimulus” should look back to the early 1990s, the last time politicians used this strategy. At the time, interest rates were still high, and President Bill Clinton’s advisers argued that a credible budget could lower interest rates by compressing the risk premium priced into yields. They were right: as deficits fell throughout the 1990s, interest rates fell, lowering borrowing costs and stimulating private sector growth (and federal tax revenues). Notably, the late 1990s was the last time the country recorded a budget surplus.

Over the past two decades, fiscal and monetary policymakers have too often been out of step. The 2010s were a mirror image of today’s situation, with fiscal policy halting growth with various “fiscal cliffs” and monetary policy doing all it could to stimulate a sluggish recovery.

With long-term risk premiums near zero today, a direct repeat of the 1990s play seems unlikely, but the wasteful combination of high deficits and high interest rates offers a similar opportunity for stimulative fiscal consolidation.

In the current environment, the impact of fiscal consolidation on growth is likely to be very small or even positive. An orderly and sustained decline in the fiscal deficit would allow monetary policy to be loosened accordingly. Given the second-order effects of lower interest rates, such as lower mortgage costs encouraging more home transactions, it is easy to see why deficit reduction deserves more political attention.

Of course, budget choices will never, and should not, be delegated to economic managers the way interest rates are delegated to central banks. And fiscal consolidation, whether by cutting spending or raising taxes, will require tough political decisions that will create winners and losers. But negotiating difficulties aside, there is now a compelling macroeconomic argument that did not exist before.

The traditional arguments for fiscal consolidation — that it will lower the risk of a debt crisis and boost growth somewhat in the long run — are sound but politically unconvincing. Cutting spending and raising taxes to set up future administrations for success will remain a tough selling point. But if politicians’ number one job is to win reelection, they should not overlook the current opportunities for fiscal consolidation.

Those who can see further than a few quarters ahead may benefit from less restrictive monetary policy as budget deficits shrink, and may find that macroeconomic tailwinds translate into political gains: Bill Clinton was re-elected in 1996 with 379 electoral votes.

Philip Karlsson-Szlezak is Global Chief Economist and Paul Schwartz is Senior Economist at the Boston Consulting Group. They are the authors of the following books: “Shocks, Crises, and Misinformation: How to Assess True Macroeconomic Risks”