THE U.S. FACES two economic challenges. Since June 2009, when the recession ended, output has grown more slowly than in prior recoveries, leaving the level well below its long-term trend. Likewise, unemployment remains well above the level usually considered full employment. Thus, although the recovery began more than three years ago, policymakers still seek further measures to stimulate the economy and, since monetary policy probably is out of ammunition, attention is focused on fiscal stimulus, meaning tax cuts or spending increases.
Looking forward, however, the U.S. is confronted with an ever-increasing ratio of debt to gross domestic product, which eventually will generate a fiscal crisis and sovereign default. This outcome is not inevitable; appropriate policy changes can avoid a fiscal meltdown, and any crisis might be decades away. Projections by the Congressional Budget Office, however, show that, under "current policies," the U.S. debt path is not sustainable. That implies a need for spending cuts and tax increases, the opposite of what is suggested by the slow recovery.
It might appear, therefore, that the U.S. is stuck between a rock and a hard place. Policymakers can fight the slow recovery with tax cuts or spending increases, but that means leaving the debt for another day and, in the meantime, making it worse--or policymakers can address the debt, but at the risk of slowing the economy or even generating a new recession.
Actually, policymakers face no such dilemma; the U.S. can have its (policy) cake and eat it, too. That is because the standard--Keynesian--argument for government spending as an anti-recession tool is misguided; the efficacy of most stimulus is debatable at best, and much current expenditure should be eliminated regardless of the debt. This means that cutting expenditure and taxes can speed the recovery in the short run and foster growth in the long run, while simultaneously putting the U.S. fiscal house in order.
The issues addressed here remain timely beyond the "fiscal cliff' discussion of tax hikes and expenditure cuts, as the U.S. still faces serious long-term fiscal debt issues. In the mainstream view, both tax hikes and spending cuts are undesirable because they will slow the economy, yet they are necessary to address the debt. In the view presented here, though, only the tax hikes are problematic; most (perhaps all) of the expenditure cuts are beneficial. Thus, if policymakers cancel (or expand) the tax hikes but retain (or expand) the expenditure cuts, they can address the short- and long-run problems in one fell swoop.
Determination of the appropriate path for fiscal policy is pressing, given the looming--and delayed---deadlines for the debt ceiling and the sequester. The last-minute "fiscal cliff' deal did not solve any of the fundamental fiscal issues. Taxes will rise for high-income taxpayers, with some possible negative effects on investment and growth. Possible spending cuts have been deferred yet again and must be addressed this month. Nothing has been done about the anticipated growth rates in transfer payments. Supporters claim the deal will reduce the 10year deficit by $600,000,000,000, a negligible impact on trillion-dollar-a-year deficits.
In the Keynesian view, therefore, policymakers face a dilemma, but this dilemma is more apparent than real. To understand why the U.S. does not face a trade-off between accelerating the recovery and avoiding a debt crisis, consider the logic behind the Keynesian perspective on fiscal policy. The Keynesian model--formulated by English economist John Maynard Keynes and employed (with little the short-term, most prices and wages are "sticky" at their existing levels. This is in contrast to the standard neoclassical assumption that prices in each market adjust quickly to equilibrate supply and demand. If prices and wages are (temporarily) stuck, then the main factor determining output is the demand for goods and services. …