As such, governments face a dilemma. The most productive spending tends to be the most politically contentious, coming in the form of big projects. It is far more tempting to make across-the-board cuts in the spending of departments, or put off capital spending in order to keep current programs going. Both of these actions have problems:
--By cutting budgets across the board, productive and useful projects will be cut along with wasteful and inefficient ones.
--Capital spending boosts growth more than current spending.
Best practice. However, it is possible to identify some economic and political principles that underlie the most effective fiscal consolidation programs:
Back to normal.Once the recession is over, and private demand is recovering, governments should act quickly:
--Continued high government spending will boost demand, causing the currency to appreciate in the short term, with money flowing into the economy as interest rates rise to constrain inflation.
--Taxes will have to rise to pay the debt.
Combined, these factors will diminish productivity, investment and consumption over the medium term as labor effort falls, corporations cut spending and investors choose government over corporate bonds. Debt will be more expensive as interest rates rise and the currency appreciates.
On the other hand, if governments act quickly to improve their finances, there will be less aggregate demand in the economy in the short term, but increased output in the long term as government interest rates fall, public debt financing is less onerous and tax rates are lower.
Cutting spending. When governments cut public spending, on balance, interest rates tend to be lower than if they raise taxes. Tax hikes drive up costs for suppliers and thus prices. Interest rates have to rise to constrain inflation. Investment and demand are lower.
Transparency. If governments explain carefully how they will improve the public finances, and stick to their promises, interest rates are likely to be lower: Investors are likely to believe that they will not cut the debt through a burst of inflation, or by exchange-rate depreciation.
Spending cuts are most likely to be effective if all political parties are on board, and if they consult widely with legislatures, civil servants and civil society groups. Cutting spending and public-sector employment by stealth tends to enrage those affected.
Selective cuts. Cutting government investment on highly economically productive areas, such as infrastructure, schools and research and development, will hamstring economic performance over the longer term. While it feels fair to cut all departments by an equal degree, some generate less economic activity in the private sector than others.
Government spending in the current downturn may serve to prop up aggregate demand, which is crucial to stimulating economic recovery. However, governments need to be vigilant of future debt-servicing costs, especially as interest rates may be much higher in the future than those experienced over the last decade. Investors and the general public will expect a coherent and transparent commitment to controlling these financing costs through fiscal consolidation over the medium to long term.
