Elections often turn on the state of the economy, especially in hardtimes. When growth and jobs are down, voters throw out incumbents – whether Spanish leftists, Frenchrightists, or Dutch centrists. TheUnited States is no exception. Three years into the Great Depression, HerbertHoover was trounced by Franklin DelanoRoosevelt. In 1980, following a severe boutof stagflation, Ronald Reagan routed Jimmy Carter.

At the same time, economic performance depends to a considerable extent oneconomic policy. The Great Depression was intensified by poor monetary policy,tax hikes, and protectionist trade policies. Likewise, loose US monetary policyin the middle of the last decade helped to set the stage for the GreatRecession by contributing significantly to an explosion of leverage and fuelingthe housing bubble that burst in 2007-2008.

The outcome of two related policy battles will be key to the economic andpolitical outlook in both the US and Europe. Thefirst is between “austerity” and “growth” – that is, short-term deficit reduction and additional fiscalstimulus. Many on the left, on both sides of the Atlantic, argue that more, not less, government spending is required tolift their economies out of recession. Those on the right believe thatgovernments’ top priority should be fiscal consolidation.

In Europe, large deficits and explodingdebt-to-GDP ratios have alarmed creditorsand provoked political tension. In particular, Germany demands more fiscal belt-tightening from heavily indebted SouthernEuropean countries, whose unions (and voters) are rejecting further austerity.While the US has thus far avoided the bond market’swrath, American political leaders confrontthe same problem of debt and fiscal sustainability.  

The second battle involves long-run structural issues:slowing the growth of government spending, reforming taxes, and increasinglabor-market flexibility. In Europe, forexample, raising the retirement age for public pensions and shrinkinggovernment employment would curtailwelfare-state excesses.

In the US, Reagan’s victory in 1980 appeared to signal that America would stop well short of the European social-welfare model. But President Barack Obamaand his congressional allies have rejected the consensus that government shouldbe only a last resort for those in need, in favor of greater dependence, forboth individuals and firms, on entitlement programs and other public spending,targeted tax breaks, regulations, and loans.

Separating the budget’s effects on the economy from thoseof the economy on the budget is tricky. There areseveral cases – Ireland and Denmark in the 1980’s, for example – in whichfiscal consolidation helped to expand the economy in the short run, as lowerinterest and exchange rates boosted confidence enough to stimulate demand.

Of course, if many of the world’s economies attempt to consolidatesimultaneously, with interest rates already low and some of the largest in amonetary union, such a favorable result is less likely. But the evidence on whether additional deficit-financedspending would quickly revive economic growth is mixed.

In a recent survey, “FiscalPolicy for Economic Growth,” I concluded that short-runmultipliers – the total change in economic activity resulting fromhigher government spending – could theoretically be as large as two when thecentral bank has reduced its target interest rate to zero. In other words, onedollar spent by the government could boost GDP by two dollars in the very shortrun.

The catch is that the multiplier turns negative by year two: extra governmentspending contracts, rather than expands, medium-term and long-term economicgrowth. Moreover, the short-run effect is lower in highly indebtedcountries, and can even be negative during economic expansions if householdsand firms, expecting higher taxes to pay for future spending, save, rather thanspend, the cash.

Postponing fiscal consolidation risks aborting it, butconsolidating too aggressively risks temporarily hindering growth. Butthose now demanding further deficit-financed stimulus must confrontconsiderable evidence that an overhang of publicdebt impedes growth for a long time. In a recent paperfollowing up on their book This Time is Different, the economists CarmenReinhart and KennethRogoff concluded that debt/GDP ratios above 90% tend to be associated withan annual growth slowdown of a full percentage point for 23 years. Thus, a debtoverhang cumulativelycosts more in lost income than a deep recession does.

Wise policy simultaneously considers short-, medium-, and long-termeffects. Both Europe and the US badly needlong-run reforms, for example, of public pensions and health care. Europe requires structural labor-market reform and must resolveits sovereign-debt overhang, banking crises, and the euro’s future. America must reform its tax code to raise revenue acrossa wider array of people and economic activity (half the US populationpays no federal income tax, and the tax code either excludes or favorablytreats many income sources).

Over the next several years – the medium term – all countries shouldimplement difficult-to-reverse fiscalconsolidation, which would persuade the private sector that a gradual ordelayed adjustment, primarily on the spending side of the budget, will occur.Successful consolidation generally relies on spending cuts rather than taxincreases – indeed, at a ratio of five or six to one. The US in the 1980’s and1990’s reduced spending by 5% of GDP and balanced its budget while growingstrongly. Canada, in the past two decades, has decreased spending by 8% of GDPand similarly prospered.

In the short run, spending flexibility is appropriate only if medium- andlong-term measures are in place. That compromise – between Germany and SouthernEurope, and between US Republicans and Democrats – should be economically andpolitically feasible.

With many citizens now struggling, political leaders face a daunting task: adopt credible medium- andlong-term reforms without derailing theeconomy in the short term. They have little economic – and perhaps even lesspolitical – margin for error.