Policy Implications of the S&P Warnings

by Veronique de Rugy

On Tuesday, I explained that while raising the debt limit might put off a downgrade disaster in August, that just gets us out of the frying pan — as Standard & Poor’s recent warning made clear. Perhaps the most important shot not heard round the world was S&P’s other admonition last week: namely, that the U.S. bond rating will be downgraded in three months’ time, if not sooner, unless we do something about government spending. Beyond raising the debt limit, S&P laid out clear criteria for avoiding a downgrade: 1) reduce the debt by about $4 trillion; 2) agree to a credible plan within three months; and 3) guarantee this new-found fiscal discipline will actually stick.

If S&P isn’t bluffing, it means that lawmakers should get serious about reducing the debt-to-GDP ratio, and they should do it quickly. Thankfully, we are not the first nation to struggle with dangerous debt-to-GDP ratio, and thankfully, the academic world has already produced great insights into what can be done to reduce this ratio without hurting the economy.

Take the work of Harvard’s Alberto Alesina and Silvia Ardagna. The economists look at 107 efforts to reduce debt in 21 OECD nations over the 1970–2007 period. Their results suggest that tax cuts are more expansionary than spending increases in the cases of a fiscal stimulus. Also, they find that spending cuts are a more effective way to reduce the debt/GDP ratio:

For fiscal adjustments we show that spending cuts are much more effective than tax increases in stabilizing the debt and avoiding economic downturns. In fact, we uncover several episodes in which spending cuts adopted to reduce deficits have been associated with economic expansions rather than recessions. We also investigate which components of taxes and spending affect the economy more in these large episodes and we try uncover channels running through private consumption and/or investment.

My colleague Matt Mitchell summarizes their result in this useful chart:

As you can see, in cases of successful fiscal adjustments (left bars), spending as a share of GDP fell by about 2 percentage points while revenue also fell by half a percentage point. On the other hand, unsuccessful fiscal-adjustment packages (right bars) were made of smaller spending reductions (only .8 percentage-point reduction) and large revenue increases.

#more#Following and building on Alesina and Ardagna’s work, Andrew Biggs, Kevin Hassett, and Matthew Jensen have a new paper that covers over 100 instances in which countries took steps to address their budget gaps. Their results are consistent with those of the Harvard economists and quite striking:

Countries that addressed their budget shortfalls through reduced spending were far more likely to reduce their debt than countries whose budget-balancing strategies depended upon higher taxes.

The typical unsuccessful fiscal consolidation consisted of 53 percent tax increases and 47 percent spending cuts. By contrast, the typical successful fiscal consolidation consisted of 85 percent spending cuts. These results are consistent with a large body of peer-reviewed research.

I cannot stress enough the importance of this work. Even in a time of crisis (or especially in a time of crisis), lawmakers tend to adopt policies for the sake of politics rather than good policy. Countries in fiscal trouble generally got there through years of catering to interest groups and pro-spending constituencies (on both sides of the political aisle), and their fiscal adjustments tend to make too many of these same mistakes. As a result, failed fiscal consolidations are more the rule than the exception: 80 percent of the fiscal adjustments Biggs, Hassett, and Jensen study were failures. The United States cannot afford to follow this pattern.

Also, for those who are not ideologically inclined toward austerity measures, it is key to remember that this research is consistent with the work of former Obama Council of Economic Advisers chairman Christina Romer and her economist husband, David Romer, which shows that increasing taxes by 1 percent of GDP for deficit-reduction purposes leads to a 3 percent reduction in GDP. In fact, Alesina and Ardagna discuss Romer and Romer  starting on page five of their paper.

Finally, Biggs, Hassett, and Jensen look at how successful different kinds of spending cuts are at reducing the debt ratio. Consistent with other studies, they find that successful fiscal consolidations focus spending cuts in two areas: social transfers, which largely means entitlements in the American context, and the government-wage bill, which means the size and pay of the public-sector workforce.

With that in mind, here are some suggestions of reforms that we should put in place today: Increase the Social Security and Medicare eligibility age, switch the cost-of-living allowance to the chained CPI, and block-grant Medicaid.

Update: Here is my Daily Caller piece today about Conquering Our Debt Problem.