$3 trillion in US deficit reduction? OK, but how you do it matters.

$3 trillion is the cost of Obama's plan that would help put America on sounder footing, many finance experts say. But such fiscal adjustments can be tricky for the economy, IMF report warns.

By , Staff writer

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    President Barack Obama walks from the Oval Office to the the Rose Garden of the White House in Washington, Monday, to talk about deficit reduction.
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President Obama tried to "go big" in proposing deficit reduction worth roughly $3 trillion over the next decade – more than he needed in order to cover the cost of his jobs plan and also meet a congressional target set in August.

Is that a good idea for the economy?

Many finance experts support the "go big" notion, although they may differ on the details. But they add an important caveat: At a time of tepid global growth, questions like "when" and "how" can be as important as how big the deficit cuts are.

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The latest reminder of this point comes from the International Monetary Fund, which warned in a Tuesday report that nations including the US face a delicate balancing act when it comes to fixing their government finances.

"Fiscal consolidation cannot be too fast or it will kill growth. It cannot be too slow or it will kill credibility," Olivier Blanchard, the IMF's economic counsellor said in the group's latest economic forecast. "The speed must depend on individual country circumstances, but the key continues to be credible medium-term consolidation."

The virtue of an Obama-size fiscal target is that it would reassure investors and other players (like the businesses and consumers who fuel economic growth and pay taxes) that the nation is getting its house in order after some years of record deficits.

The Obama administration estimates that its proposal would bring the federal deficit down to 2.3 percent of US gross domestic product in 2021. "By comparison, if we did nothing, the deficit would be 5.5 percent of GDP in 2021," the White House says. The ratio of national debt to GDP would stop rising.

Republicans have offered their own plans – emphasizing spending cuts and avoiding tax hikes – to get to a similar fiscal position.

The task ahead is for the two sides to try for a deal, whether it's big (such as in the $3 trillion range) or smaller.

The recently passed Budget Control Act puts the onus on a bipartisan supercommittee of 12 lawmakers from the House and Senate. If they don't reach a deal that can be approved by Congress and signed by Obama, then an automatic deficit-reduction plan – $1.2 trillion in spending cuts – will take effect.

But a risk in pursuing deficit cuts is that it might be the opposite of a "fiscal stimulus" for the economy – hurting growth in the near term. Not all forecasters take that view, but it's the mainstream position among economists.

A recent report from the investment firm Goldman Sachs, for example, argues that deficit reduction is needed but that it "is likely to act as a significant drag on growth in the US." Thus policymakers should be mindful of a "speed limit" of fiscal adjustment, economist Sven Jari Stehn argues in the report.

Such an adjustment will be easier if the private-sector economy gathers momentum, and thus is ready to pick up slack as the government begins to spend less, and possibly tax more.

The Obama administration says it is taking this factor into account – such as in its call for more tax cuts and infrastructure spending in 2012 and waiting until 2013 to impose higher taxes on high-income households.

Treasury Secretary Tim Geithner also argued Monday that any negative impact from raising taxes would be softened if the moves are part of a sweeping simplification of the tax code, which makes the US a more appealing place for businesses to invest.

In all, the Obama plan calls for $1.5 trillion in higher tax revenues, equal to about 1 percent of GDP over the decade. The plan also calls for spending cuts in both discretionary programs and mandatory ones like Medicare. And Obama envisions big savings from the wind-down of military involvement in Iraq and Afghanistan.

Separate from the thorny politics of tax reform, policymakers have some tricky choices as they weigh Obama's proposal and other ideas.

The economy needs better job growth right now, but it also needs good long-term growth. Getting fiscal policy right is important for both goals.

Mr. Blanchard at the IMF said that fiscal reforms have already started in the US and many European nations, but that so far the private sector is not picking up the baton and driving job growth as fast as many economists had hoped.

"Tight bank lending, the legacy of the housing boom, and high leverage for many households all turn out to be putting stronger brakes on the recovery than we anticipated," he said.

In the US, a loss of confidence in both Obama and Congress may also be weighing on private-sector spending and investment.

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