Threading the Fiscal Needle

With many citizens in the US and Europe now struggling, political leaders face a daunting task: adopt credible medium- and long-term reforms without derailing the economy in the short term. They have little economic – and perhaps even less political – margin for error.

PALO ALTO – Elections often turn on the state of the economy, especially in hard times. When growth and jobs are down, voters throw out incumbents – whether Spanish leftists, French rightists, or Dutch centrists. The United States is no exception. Three years into the Great Depression, Herbert Hoover was trounced by Franklin Delano Roosevelt. In 1980, following a severe bout of stagflation, Ronald Reagan routed Jimmy Carter.

At the same time, economic performance depends to a considerable extent on economic policy. The Great Depression was intensified by poor monetary policy, tax hikes, and protectionist trade policies. Likewise, loose US monetary policy in the middle of the last decade helped to set the stage for the Great Recession by contributing significantly to an explosion of leverage and fueling the housing bubble that burst in 2007-2008.

The outcome of two related policy battles will be key to the economic and political outlook in both the US and Europe. The first is between “austerity” and “growth” – that is, short-term deficit reduction and additional fiscal stimulus. Many on the left, on both sides of the Atlantic, argue that more, not less, government spending is required to lift their economies out of recession. Those on the right believe that governments’ top priority should be fiscal consolidation.

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