Memo to Policymakers: Expectations Matter

Our policymakers need to focus more how shaping and managing fiscal expectations can help us get our fiscal house in order while supporting growth at the same time. (Hint: No, it’s not magic. It’s thoughtful policy design – which basically means taking great care with timing and composition.)

Announcing a credible plan to get our fiscal house in order can have well-recognized benefits - even if deficit reduction is back-loaded (probably advisable in view of current weakness). Such an announcement would offer support for the economy through the expectations channel: with lower debt expectations, normal crowding out effects would be diminished and interest rates would not rise as usual as the economy recovers. Keeping longer term interest rates lower in the near term and increasing consumer and business confidence that we are reasonably managing our fiscal affairs rather than governing by chaos would help support the recovery. And we need all the support for the economy we can sensibly muster.
Further reading (just a sample of what’s out there in the policy and research literature, for wonks to get up to speed):
- Fed Chairman Bernanke’s testimony before the Joint Economic Committee (April 14, 2010).
“Although sizable deficits are unavoidable in the near term, maintaining the confidence of the public and financial markets requires that policymakers move decisively to set the federal budget on a trajectory toward sustainable fiscal balance. A credible plan for fiscal sustainability could yield substantial near-term benefits in terms of lower long-term interest rates and increased consumer and business confidence. Timely attention to these issues is important, not only for maintaining credibility, but because budgetary changes are less likely to create hardship or dislocations when the individuals affected are given adequate time to plan and adjust. In other words, addressing the country's fiscal problems will require difficult choices, but postponing them will only make them more difficult.”
- Angel Gurria, head of theOrganization for Economic Cooperation and Development (OECD), the industrial country governments’ research group, statement to the press concerning the release of OECD Economic Outlook No. 85:
“Early announcement of [medium-term fiscal consolidation] plans, even if their implementation is conditional on actual economic developments, will help to anchor medium-term expectations of savers and investors and thereby keep down the cost of financing much higher debt levels.”
- Maria Gabriella Briotti, European Central Bank, Fiscal Adjustment Between 1991 and 2002: Stylized Facts and Policy Implications, (2004):
“[E]xpansionary effects are also possible if fiscal policies prompt a change in the expectations of economic agents about their future wealth (demand-side effects) and/or contribute to improving the competitiveness of the economy (supply-side effects).”
- Read Alberto Alesina, Harvard, Fiscal Adjustments: Lessons from Recent History (April 2010).