How rapidly should governments correct their fiscal deficits, which in the long run are unsustainable in the US, UK, Japan and many countries in the eurozone?
That is a question which continues to dominate the policy debate among economists. Rapid correction undoubtedly damages near term economic growth, but is intended to reduce the risk of a sovereign debt crisis coming suddenly out of the blue. Slow correction does the opposite. There is no theoretically “correct” policy on this. The result depends on how the near term loss of output should be weighed against the risk and consequences of a fiscal crisis, which is an empirical matter. (See this earlier blog: Assessing the risk of a financial crisis, which attempts to measure the risk of fiscal crisis.)
It is possible for reasonable economists to disagree about this, and for the “right” policy to be different in different countries. However, occasionally a piece of research comes along which changes the “dial” on the debate, and I believe that applies to the important Brookings Paper published last week by Brad DeLong and Larry Summers. This paper, which is well summarised here and here, essentially implies that the trade-off between near-term GDP growth and the probability of fiscal crisis can be irrelevant, because temporary fiscal expansions, at a time when interest rates are at the zero bound, are eventually self-financing. Read more