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The New Economy

Is US a model for austerity-wary Europe?

Despite its sluggishness, the US economy is growing while Europe's is contracting. A rising number of policymakers blame Europe's austerity moves.

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No one denies that the US and other indebted nations will have to embrace austerity at some point to reduce their rising pool of red ink. The big debate has always been about timing. Here's the problem with starting austerity too early when the economy is still too weak, according to Lawrence Summers, a former economic adviser to President Obama, writing Monday in The Washington Post. When official interest rates are near zero, every 1 percent cut in government spending reduces the size of its economic output by 1 percent to 1.5 percent. So trying to reduce your debt-to-asset ratio through spending cuts just reduces your assets, so the ratio never goes down.

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Take Greece's austerity plan: In exchange for a bailout, it has agreed to cut spending so that it will average a budget surplus of 4.5 percent of gross domestic product (GDP) per year between 2014 and 2020 (before debt payments). Under official projections, Greece will be able to reduce its debt-to-GDP ratio from 160 percent to 120 percent by the end of the period. Private forecasters are skeptical. For example, Greece's GDP will fall 5 percent this year, according to Standard & Poor's, not 4.3 percent as the official forecast calls for. Realistically, according to the Royal Bank of Scotland, Greece's actual debt-to-GDP ratio will be no better off in 2020 than it is today.

Of course, embracing growth doesn't mean that a nation can keep up piling on debt. At some point private investors lose confidence and quit financing its operations at reasonable interest rates, as happened with Greece. So how can a nation cut its debt without shrinking its economy?

By backloading the cuts for a period when the economy is growing more robustly, argues Christina Romer,  another former Obama economic adviser who now teaches economics at the University of California, Berkeley.

"The core of a more sensible approach is to pass the needed budget measures now, but to phase in the actual tax increases and spending cuts only gradually – as economies recover," she wrote in an op-ed for The New York Times last Sunday. "What's to stop policy makers from promising the moon and not delivering? History shows that countries have done such gradual consolidations before. In 1983, for example, the United States passed a Social Security reform plan that was backloaded in the extreme: it specified tough changes, including higher taxes and increases in the retirement age, to be phased in over almost three decades."

Of course, history also shows that lawmakers often don't follow through on making the tough cuts that they've agreed to. If the US fails to reduce its unsustainable deficits, then the holders of its debt eventually will lose confidence, forcing far harsher taxes and spending cuts than US politicians are contemplating.

Congress mush also overcome the sharp partisan divide over how to rein in spending: through spending cuts or tax increases or both, which will play out in the upcoming debate over tax reform. Optimists on the left and the right think Republicans and Democrats can strike a grand bargain on tax reform, perhaps as early as the lame duck session of Congress right after the election.

That's not only achievable, it would be a signal accomplishment, Forbes magazine publisher Steve Forbes told an audience in Boston earlier this week. If the US can get the tax and spending balance right, it will be an example for Europe and the world to follow.

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