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John Merrifield and Barry Poulson

The Great Recession and slower economic growth in recent years have been accompanied by a discontinuous increased in debt/GDP ratios in most OECD countries, most notably the U.S. This debt burden has raised questions regarding the ability of these countries to pursue discretionary fiscal policy. This question has become more important as countries encountered the limits of accommodative monetary policy.

Some economists argue that the current low interest rates have expanded the fiscal space for countries to pursue expansionary fiscal policies, using long term bonds to lock in the interest rates. Deficits in the medium term are justified as a stimulus to economic recovery, and to finance investments for long term economic growth. That view is challenged by economists who argue that high debt/GDP ratios have reduced, and in some cases eliminated, fiscal space; and that at least for some countries pursuit of expansionary fiscal policies exposes them to the risk of default.

The concept and measurement of fiscal space is a controversial issue in macroeconomic policy. Fiscal space is estimated as the distance between actual debt levels and their estimated limit. Debt limits are measured by the level of debt at which the government defaults and loses market access, so that it cannot continue to service the debt. There are different ways to measure fiscal space, and this has led to considerable controversy regarding the sustainability of fiscal policy.

Further complicating this issue is the enactment of new fiscal rules. In recent years many OECD countries responded to increased debt burdens by enacting fiscal rules designed to reduce debt/GDP ratios below tolerance levels. Among the most successful of these are European countries relying on national as well as supranational fiscal rules that require budget constraints whenever deficits and debt exceed tolerance levels. To the extent that these new fiscal rules are effective, this expands fiscal space, improving their capacity to pursue countercyclical fiscal policies and policies to promote economic growth. In that sense fiscal space cannot be separated from the fiscal rules in place constraining fiscal policy.

In a forthcoming book with Lexington Press, we explore fiscal space and fiscal rules in the U.S. If the U.S. had enacted fiscal rules to constrain deficits and debt over the past two decades, as some OED countries have, we could have reduced debt below tolerance levels relying on orthodox fiscal policies. A modest reduction in the rate of growth in spending, and entitlement reform could have balanced the budget. A cyclically balanced budget would have resulted in a sustainable fiscal policy, and the nation would not have had to respond to the Great Recession with a fiscal bailout that doubled the national debt.

Unfortunately, addressing the debt crisis today is a more formidable task, requiring unorthodox fiscal policies beyond anything proposed by Congress or the President. New fiscal rules would have to constrain the growth in discretionary spending to less than 1% per year for the next two decades. The fiscal rules would require that any increase in deficits or debt above tolerance levels would trigger even more stringent limits on the growth in discretionary spending.

Even with more effective fiscal rules in place the federal government will have to generate about $600 billion in savings, earmarked for debt reduction each year for two decades. This will require substantial savings from entitlement reform and sale of federal assets, with the proceeds earmarked for debt reduction.

With a cyclically balanced budget the federal government would have some discretion to pursue a countercyclical fiscal policy. If recessions are mild, these fiscal policies could be maintained in the long run. However, this rosy scenario is predicated on the assumption that we avoid major headwinds, such as slower economic growth, higher interest rates, higher health care costs, etc. If the nation experiences another financial crisis, comparable to the Great Recession, it is not clear that we could achieve a sustainable fiscal policy, even with effective fiscal rules and fiscal reform.

Keynesians, such as Paul Krugman, argue that the nation has ample fiscal space, and should pursue expansionary fiscal policies to stimulate economic growth. But our research reveals that the nation can no longer muddle along as we have for half a century, incurring deficits and accumulating debt. Expansionary fiscal policies such as those pursued by the Obama administration, would trigger deficits and debt levels that expose the country to default and loss of access to international capital markets.

At this point in time our nation has no fiscal space, our debt burdens are already beyond tolerance levels. Prudent fiscal rules and fiscal reforms must be enacted immediately, and maintained for the foreseeable future to restore a sustainable fiscal policy. The era of Keynesian stimulus is over, our nation must return to an historical tradition of balanced budgets.


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