US Budget Deficit Reduction
Don't overdo it

iscal deficits and public debt in the United States are not unusually high by international standards, Willem Buiter told a CEPR lunchtime meeting on November 13. Careful comparisons revealed that the US general government deficit as a proportion of GDP is slightly below the OECD average, and even the US federal deficit is no larger a proportion of GDP than in other major industrial countries. But the low rate of saving by the US private sector meant that a reduction in the primary (non-interest) general government deficit by between 1.0 and 1.5% of GDP was needed in order to stabilize the internal and external debt burdens of the United States. Unless it were accompanied by a moderate fiscal expansion and a significant relaxation of monetary policy in Britain, Germany and Japan, however, a US contraction would produce a world recession whose effects, because of the low exchange rate of the dollar, would be concentrated in Europe and Japan.
Willem Buiter is a Research Fellow in CEPR's International Macroeconomics programme, and is Visiting Professor of Economics at the London School of Economics during 1987-8. His talk was based on the research reported in Discussion Paper No. 210, which he has pursued with the financial support of the Ford Foundation and the Alfred P Sloan Foundation.
Buiter argued that it was misleading to compare the US federal deficit with the more comprehensive public sector deficits in other countries. In fact, as a proportion of GDP the US general government deficit (which includes state and municipal as well as the federal government) was slightly below the OECD average (see Table). In addition the ratio of public debt to GDP in the United States was below the average for the G7 countries and is not rising much faster than this average. Discussions of the US external debt have also been excessively alarmist, according to Buiter. While its large and persistent current account deficit meant that the United States is set to become a net external debtor, it has not yet reached that position.
Even though international comparisons revealed that fiscal deficits and public debt in the United States were not unusually high, Buiter nevertheless agreed that the US federal deficit should be reduced. The rate of private savings in the United States is significantly below that of the rest of the OECD and has recently fallen below the share of private investment in GDP. If no measures are taken to stimulate private saving and if a reduction in private investment is considered undesirable, then a modest reduction in the US general government deficit is needed in order to correct the external deficit. This reduction should be announced immediately and phased in over a period of several years to minimize its contractionary effect on aggregate demand, although Buiter conceded that most of the cuts would have to be `up front' in order for the measures to be credible.
A US fiscal contraction brought with it, however, the danger of world recession. Even before the recent global stock market collapse, global economic growth was slowing, and the crash, by reducing private sector financial wealth, has made a global recession quite likely, according to Buiter. He argued therefore that fiscal policy outside the US should become expansionary to offset part of the contractionary effects of US fiscal tightening. To the extent that global fiscal policy becomes on balance more restrictive, global monetary policy should also become more expansionary.
Is the threat of government insolvency in the industrial countries an obstacle to such expansionary fiscal policy? The question of solvency can be analysed in a straightforward manner using the concept of the government's intertemporal budget constraint, as explained in Buiter's paper in the first issue of Economic Policy (October 1985). In Discussion Paper No. 210, Buiter analyses the present fiscal position of Europe and Japan using this concept. He concludes that Britain, Germany and Japan have ample room for a fiscal expansion, of up to 2% of GDP in the UK case, even though inappropriate treatment of revenues from privatization causes true government borrowing in Britain to be understated by up to £5 million per year. In addition there is considerable real slack in all three economies, which can be expanded by supply-side-friendly fiscal measures such as cuts in employers' social security contributions, private investment subsidies, other cuts in direct taxation, and increased investment in infrastructure. This is particularly true for Germany and Japan in view of their current account surpluses. Without further policy changes, a depreciation of the dollar only redistributes a given volume of world demand towards the US and away from Europe and Japan. Monetary policy should therefore become more expansionary in West Germany, Japan and Britain in order to reduce short-term nominal and real interest rates and prevent a further decline of the dollar.
Buiter emphasized that such a coordinated global response was particularly important for Britain. The UK economy was small (producing about 6% of world GDP), very open to international trade (with exports and imports each about 33% of GDP), and wide open to international financial shocks. It could not therefore hope to insulate itself completely against a global recession. Heaping abuse on the American government because of its deficit is counterproductive, said Buiter. A unilateral US fiscal contraction without moderate fiscal expansion and a significant relaxation of monetary policy in the UK, Germany and Japan will produce the outcome these three countries least desire: a world recession whose impact is concentrated, because of the decline in the dollar, in Europe and Japan.