CBO finds that reducing budget deficits, thereby bending the curve on debt levels, is a net positive for economic growth. CBO finds a dichotomy, however, between the short-term and longer-term impacts of deficit reduction. For instance, CBO’s short-term economic models are driven mainly by demand-side factors. According to these short-term models, deficit reduction that lowers government spending leads to a temporary reduction in economic output due to the assumed reduction in consumption as a result of lower government transfers. These models assume government spending has a “fiscal multiplier” in excess of 1, meaning that its reduction leads to an outsized reduction in overall economic output. Of course, every dollar the government spends must be taxed or borrowed from the private sector.
Although CBO believes that deficit reduction may lead to lower economic growth over the short term, some economists offer a contrasting view. They argue that a country’s debt build-up can be so large that longer-term fiscal concerns essentially start to bleed into the present, affecting short-term economic activity. The extreme example is a sudden, full-blown debt crisis like the one that fiscally troubled countries in Europe have experienced. But there is also a less-noticeable, slowly evolving type of crisis that can grip a debt-burdened economy—the crisis of uncertainty and waning confidence in the will of policymakers to deal with the government’s unsustainable fiscal trajectory. Investors and businesses make decisions on a forward-looking basis. They know that today’s large debt levels are simply tomorrow’s tax hikes, interest-rate increases, or inflation—and they act accordingly. It is this House Budget debt overhang, and the uncertainty it generates, that can weigh on growth, investment, and job creation.
For instance, Stanford economists John Cogan and John Taylor recently studied fiscal-consolidation strategies that use a so-called “Neo-Keynesian” economic model to take into account how consumers and businesses might react to a country’s future fiscal trajectory. For example, forward-looking consumers and businesses may expect future tax hikes, and plan accordingly, if a country continues to build up large amounts of debt that will ultimately need to be paid off. In this study, Cogan, Taylor, and their fellow authors find that “even in the short-run, the consolidation of government finances is found to boost economic activity in the private sector sufficiently to overcome the reduction in government spending.”66
- No reference to Heritage CDA analysis of the plan, as opposed to the version two years ago. For entertainment, see    
- Reference to a “Neo Keynesian” model. Not sure what that is, although this is what Wikipedia says. I think Representative Ryan means to refer to a “New Keynesian” model.
- Footnote 66 refers to the “Fiscal Consolidation Strategy”. The authors use a New Keynesian DSGE to simulate out the implications of fiscal consolidation cited in the plan. I can’t claim to have carefully read the entire paper, but I can’t figure out what is assumed for monetary policy – which is somewhat important if one is considering the short run impact as well as the long run effect (see this paper).
- The model has immediate effects from fiscal consolidation. That’s because in the long run, the model is Ricardian, despite the short run rigidities introduced by sticky prices and rule-of-thumb consumers. As I’ve noted here, not all NK DSGE’s have this characteristic.
- A small point. CBO does not assume all fiscal multipliers are greater than one, as documented in innumerable reports (what’s the point of full disclosure if nobody reads!). As I’ve observed (e.g., ) some transfers multipliers are less than unity (as theory suggests they should).
- On a lighter note, I particularly liked the sentence: “Although CBO believes that deficit reduction may lead to lower economic growth over the short term, some economists offer a contrasting view.” It reminded me of the TV show “Ancient Aliens” where the narrator observes that some people believe “X” (Nazca lines are signs to folks from Orion, etc.). While I’m sure that there are some serious economists who do believe in the contrasting view (e.g., Taylor, Wieland), it would’ve been more honest to note where the preponderance of views in the economics profession lies.