Excessive Fiscal Tightening – A Major Worry

by: Scott_Brown

Excerpt from Raymond James Economist Dr. Scott Brown's latest economic commentary:

Studies of past recessions show that downturns associated with financial crises tend to be more severe and longer-lasting, with gradual recoveries. Simply put, it takes a long time to repair financial damage. The restoration of household, business, and banking balance sheets does not happen overnight. Studies also point to a common error made in these recoveries – that is, policy is often tightened too soon. Chairman Bernanke is a student of the Great Depression – so the Federal Reserve seems unlikely to make that mistake. However, there is a growing public mood to do “something” about the federal budget deficit. State and local governments do not have the luxury of borrowing. Increased taxes and cuts in government services have shaved a few percentage points off GDP growth in recent quarters and reduced nonfarm payrolls. In Europe, austerity has spread beyond the “problem” countries and fiscal contractions are poised to weaken the recovery in 2011. While well intentioned, excessive fiscal tightening is bad economics.

In the U.S., there have been efforts over the years to enact legislation to require a balanced budget. At its worst, a hard budget balance would be countercyclical, making recessions worse and booms more frothy. In a downturn, tax revenues normally fall, pushing the budget out of balance. To return to balance, the government could raise taxes or cut spending, but these moves dampen growth even more. A balanced budget requirement could be nullified during recessionary periods or in times of war, but that’s not as clear as it sounds. (For example, would Congress have to officially declare war? What do we mean by a recessionary period?). It may make sense to work toward a balanced budget (or perhaps a small deficit) over the course of the business cycle, running surpluses during booms and deficits during busts. That sounds easy, but there’s always a strong political incentive to spend more or to cut taxes during an economic boom. That’s seen clearly at the state level.


One issue in deficit spending is deciding how much is enough to carry us through. Removing fiscal stimulus too soon risks derailing the recovery. Anti-deficit sentiment has already hampered a push for further stimulus to support job growth. Across the Atlantic, austerity moves threaten to dampen European economic growth in 2011. Long term, deficit reduction is important, but short term, it’s just foolish.