Economics: Fiscal Contraction Hurts Economic Expansion -- Except ...

The general presumption is that fiscal contraction — cutting spending or raising taxes, or both — will immediately slow the economy relative to the growth it would have had otherwise.

Under four conditions, fiscal contractions can be expansionary. But none of these conditions is likely to apply in the United States today.

First, if there is high perceived sovereign default risk, fiscal contraction can potentially lower long-term interest rates.

Second, it is highly unlikely that short-term spending cuts would directly increase confidence among households or companies, particularly with employment still around 5% below its precrisis level.

Third, if monetary policy becomes more expansionary while fiscal policy contracts, this can offset to some degree the negative short-run effects of spending cuts on the economy.

Fourth, tighter fiscal policy and easier monetary policy can, in small, open economies with flexible exchange rates, push down (that is, depreciate) the relative value of the currency — thus increasing exports and making it easier for domestic producers to compete against imports.

For more, see Fiscal Contraction Hurts Economic Expansion by Simon Johnson, June 23, 2011 at Economix.