We told you yesterday about a new study detailing the importance of fiscal space in determining policy responses to economic downturns. To recap: The paper by economists Christina and David Romer found that countries with high debt-to-GDP ratios respond less aggressively to counteract financial shocks, and that more muted response translates to greater economic damage.
In a Washington Post piece, economist Jared Bernstein explains why this matters: “If you think of the next recession as a house fire, then these policy buckets are water buckets that need to be filled to the brim if we’re to effectively fight the blaze,” he writes. Instead, it’s almost certain that our buckets will at least look pretty dry when the next fire breaks out.
In principle, having a high debt-to-GDP ratio shouldn’t affect how policymakers respond to the next downturn, Bernstein argues. High debt levels bring economic risks, he says, but “there’s no good economic rationale that should lead policymakers to throw less fiscal water on the fire with high vs. low debt ratios.”
But the politics and perceptions surrounding high debt levels make fiscal policymakers more reluctant to take action. “In my interpretation, it’s not that fiscal policy is less effective at high debt levels. It’s that policymakers simply won’t do much of it when they’re staring down debt-to-GDP levels well above average.”