As economic recovery sags, would a federal budget deal hurt or help?

An underlying problem is that economic recoveries following a financial crisis tend to be slower than typical rebounds from recession. Millions of US consumers continue to struggle with high levels of household debt, banks are still burdened by troubled loans, and the government – partly because of stimulus efforts – has seen its own debt level soar.

The risk is that high debt loads will hamper economic growth for years to come (see chart). In its mainstream forecast, the Congressional Budget Office currently envisions tepid growth of about 2.5 percent a year during the second half of this decade.

Sometimes, efforts to fix the problem can bring complications of their own. Just look at Greece. To retain a credit lifeline from neighboring nations, the country has embarked on an austerity program while also paying sky-high interest on new loans. In its case, government spending cuts appear to be crimping economic activity and tax revenues.

By contrast, if a nation can speed up the growth rate for its gross domestic product, that can help not only job creation but also the process of digging out of debt.

Some economists argue that if the goal is to get unemployment down and growth up, now is the wrong time to make big changes to the budget.

"It is not the time to cut spending or raise taxes," given how fragile the economy is, says Robert Shapiro, a former economic official in the Clinton administration who is now at Sonecon, a policy consulting firm in Washington.

To those in this camp, a key risk is that government retrenchment (such as spending cuts) could pull a leg out from under an already weak economy. That could hurt both jobs and the fiscal outlook, since tax revenues rise in a healthy economy.
A better approach, they argue, would to plan fiscal reforms that don't kick for a year or two.

But others say that stimulus programs, which add more debt to an already high-debt economy, have had only marginal impact thus far, so a different approach is warranted.

"My sense is that some policy that puts the fiscal house in order ... is the only way out," says Alberto Alesina, a Harvard University economist who has studied the relationship between government budgets and GDP.

By his research, nations working to control their debt levels achieve the strongest economic growth when they emphasize spending cuts more than tax increases. Mr. Alesina cites Canada in the 1990s as among the examples of nations that have successfully pared down debt (as a percentage of GDP) while also encouraging economic growth. By contrast, he says, an Italian effort to adjust public finances through tax increases backfired, leaving Italy with a still-high debt level.

For now, most Republicans are ruling out tax hikes. They generally say they'll vote to raise the debt ceiling (allowing the Treasury to borrow more) only if the move is accompanied by meaningful commitments on spending cuts and no increase in tax revenues.

Although the two parties are sharply divided on some key issues, including how to curb health-care costs, some important common ground also exists. Prominent members of both parties have embraced the idea – espoused last year by President Obama's bipartisan fiscal commission – of seeking about $4 trillion in deficit reduction over the next decade, to stabilize public debt as a share of GDP. And many on both sides agree on the need for sizable spending cuts. (But Republicans tend to want bigger cuts, and sooner, than Democrats.)

The two sides also share an interest in tax reform aimed at simplifying the code and making the US more competitive globally as a place to do business.

A "grand bargain" that even includes changes to Medicare or Social Security may not be reachable as part of a vote on the debt ceiling this summer. But the existing areas of agreement could, with some political statesmanship, become building blocks in a broader fiscal restructuring.

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