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Cutting the deficit too soon could lead to a Depression

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Financial Times How to walk the fiscal tightrope

How to walk the fiscal tightrope

Highly respected senior economics and financial writer for Financial Times, Martin Wolf, argues against Niall Ferguson’s belief that the US must immediately cut spending to deal with the deficit. Martin writes:

Jumps in fiscal deficits are the mirror image of retrenchment by battered private sectors. In the US, the financial balance of the private sector (the gap between income and expenditure) shifted from minus 2.1 per cent of GDP in the fourth quarter of 2007 to plus 6.7 per cent in the third quarter of 2009, a swing of 8.8 per cent of GDP (see chart). This massive swing occurred despite the Federal Reserve’s efforts to sustain lending and spending. Similar shifts occurred in other crisis-hit countries.

If these governments had decided to balance their budgets, as many conservatives demand, two possible outcomes can be envisaged: the plausible one is that we would now be in the Great Depression redux; the fanciful one is that, despite huge increases in taxation or vast cuts in spending, the private sector would have borrowed and spent as if no crisis at all had happened. In other words, a massive fiscal tightening would actually expand the economy. This is to believe in magic.

…as the McKinsey Global Institute has also noted in a recent report: “Historic deleveraging episodes have been painful, on average lasting six to seven years and reducing the ratio of debt to GDP by 25 per cent”. The only ways to accelerate this would be via mass bankruptcy or inflation. If these are ruled out, what might support demand, while deleveraging continued? If fiscal policy is also ruled out, the only option would be foreign demand. But who is likely to offset contracting demand in the US and other hard-hit economies? Nobody, alas, is the answer.

This is the position I’ve argued for months, even though I’ve received criticism and arguments from my Libertarian friends. Yes, reducing the deficit is vital for the economy’s long term health, but it must be done in a measured way to prevent additional shocks to an already fragile economy. What Republicans have been advocating by immediate budget and deficit reduction is both economically irresponsible and would cause even more harm to American businesses and families.

Written by Valerie Curl

February 18, 2010 at 8:26 PM

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