Blog Post

The Great Austerity Debate

Is it time for fiscal consolidation or stimulus? Should governments cut or increase spending? Once again the issue is a matter of dispute among policy-makers and economists in Europe and the United States. Citizens, having been told in 2008-09 that the imperative was to stimulate the economy, and in 2010-2011 that the time had come for retrenchment, are understandably confused. Should priorities once again be reversed?

By: Date: November 12, 2012 Topic: Macroeconomic policy

Is it time for fiscal consolidation or stimulus? Should governments cut or increase spending? Once again the issue is a matter of dispute among policy-makers and economists in Europe and the United States. Citizens, having been told in 2008-09 that the imperative was to stimulate the economy, and in 2010-2011 that the time had come for retrenchment, are understandably confused. Should priorities once again be reversed?

At the International Monetary Fund’s annual meeting in October, the IMF’s chief economist, Olivier Blanchard, fueled the controversy by pointing out that governments in recent times have been inclined to underestimate the adverse growth consequences of fiscal consolidation. They have typically assumed that to cut public spending by a dollar would reduce GDP by 50 cents in the short term; according to Blanchard, the true outcome in current conditions is a decline by between 90 cents and 1.70. That is a big gap, but also a perplexing finding: how can there be so much uncertainty?

Contrary to what such forecasting disparities may suggest, economists actually know a lot about the consequences of fiscal policy, at least much more than they used to know. Until the 1980s, it was routinely assumed that the so-called "multiplier" – the ratio of change in GDP to the change in government spending – was stable and larger than one. A dollar less of spending was believed to reduce GDP by more than one dollar, so that fiscal retrenchment was economically costly (while, conversely, stimulus was effective).

Then came the counterrevolution, which advanced a long list of reasons why the multiplier was likely to be much lower. Cut spending, it was said, and inflation would fall. The central bank would lower interest rates, households would spend in anticipation of lower taxes, and business confidence would be boosted. In the end, there would be little, if any, damaging impact on output.

Economists are a fractious lot, but they are also stubborn investigators, so the controversy prompted new research into the effects of budgetary retrenchments. New methods were developed to measure their impact, new approaches were introduced to take into account the possibility that the multiplier could vary over time, and new data were compiled to take better account of actual budgetary decisions.

All of this effort paid off. There is now convincing evidence that the same decision to cut public spending can have very different consequences, depending on economic conditions. This may seem like paradise for policy wonks, but it also has significant implications for government choices.

The adverse short-term growth effects of a spending cut are likely to be largest when the economy is already in a recession, trade partners are also cutting spending or raising taxes, the central bank’s interest rate is already near zero, and markets have no particular worries about the state’s ability to repay its debt. In such conditions, typically those of 2009, the multiplier can be close to two. So it would have been lethal to embark on fiscal consolidation back then. It was right to stimulate.

Conversely when the economy is in an upswing, the effects of fiscal retrenchment are unlikely to be damaging. In a boom the multiplier can be 0.5 or even lower. So it was right to start planning for a change of gear when the recovery started to materialize. And it is right to be cautious with retrenchment as long as the recovery remains weak.

Things are trickier when public finances are under acute stress and markets worry about sovereign solvency, as is the case in southern Europe. There is scant empirical evidence for this set of conditions because such cases were rare until recently. But it is logical to consider that restoring the sustainability of public finances can have strongly positive effects on confidence and bond rates. At the same time, if the economy is already contracting sharply, as it often does in such situations, a spending cut is bound to have serious negative effects on domestic demand.

The best way out of the dilemma is to go for actions that improve long-term public finances without producing a negative short-term effect, such as public pension reform. An increase in the retirement age, for example, improves the perspective for public finances, but it does not weigh on short-term demand.

More generally, measures that credibly signal stronger public finances in the future are desirable – assuming, obviously, that governments still have some credibility. When it is squandered, as in Greece, promises have no value, and governments have no choice but to cut spending immediately.

Understanding which conditions are being met when and where helps to set the agenda for today. The global economy currently is slowing; several European countries – and the euro area as a whole – are in a recession; central bank interest rates are exceptionally low, and unlikely to rise soon; and most advanced countries are cutting public spending. This calls for caution with consolidation efforts. At the same time, public-debt ratios are still rising, and several countries have lost market access or at risk of losing it, owing to the precarious state of their public finances. This, by contrast, implies a need for retrenchment.

The prescription for policymakers is thus fourfold:

·Whenever public-finance sustainability is at stake (which is pretty much everywhere in the advanced world, except Australia, Canada and a few northern European countries, including Germany), governments should keep on consolidating, but at a moderate pace.

·Governments should not increase consolidation efforts just because the slowdown reduces tax revenues, and should not aim at headline deficit targets for next year.

·In acute fiscal stress, governments cannot afford to slow down consolidation. But they should place as much emphasis as possible on spending reforms that credibly improve the outlook while having limited adverse short-term effects.

·Finally, officials everywhere should invest in institutions that help to convince markets of their commitment to public-finance sustainability.

In hazardous conditions, officials should not rely on rosy scenarios and hope that they will be believed. Rather, they should tell clearly to markets and citizens how they reason and what they intend to do.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Read about event More on this topic
 

Upcoming Event

May
25
14:30

How can we support and restructure firms hit by the COVID-19 crisis?

What are the vulnerabilities and risks in the enterprise sector and how prepared are countries to handle a large-scale restructuring of businesses?

Speakers: Ceyla Pazarbasioglu and Guntram B. Wolff Topic: Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic
 

Upcoming Event

May - Jun
31-1
10:30

MICROPROD Final Event

Final conference of the MICROPROD project

Speakers: Carlo Altomonte, Eric Bartelsman, Marta Bisztray, Italo Colantone, Maria Demertzis, Wolfhard Kaus, Javier Miranda, Steffen Müller, Verena Plümpe, Niclas Poitiers, Andrea Roventini, Gianluca Santoni, Valerie Smeets, Nicola Viegi and Markus Zimmermann Topic: Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event
 

Past Event

Past Event

[Cancelled] Shifting taxes in order to achieve green goals

[This event is cancelled until further notice] How could shifting the tax burden from labour to pollution and resources help the EU reach its climate goals?

Speakers: Niclas Poitiers and Femke Groothuis Topic: Green economy, Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 12, 2022
Read about event More on this topic
 

Past Event

Past Event

How are crises changing central bank doctrines?

How is monetary policy evolving in the face of recent crises? With central banks taking on new roles, how accountable are they to democratic institutions?

Speakers: Maria Demertzis, Benoît Coeuré, Pervenche Berès, Hans-Helmut Kotz and Athanasios Orphanides Topic: Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 11, 2022
Read article Download PDF More by this author
 

Book/Special report

European governanceInclusive growth

Bruegel annual report 2021

The Bruegel annual report provides a broad overview of the organisation's work in the previous year.

By: Bruegel Topic: Banking and capital markets, Digital economy and innovation, European governance, Global economy and trade, Green economy, Inclusive growth, Macroeconomic policy Date: May 6, 2022
Read article Download PDF
 

Policy Contribution

European governance

Fiscal support and monetary vigilance: economic policy implications of the Russia-Ukraine war for the European Union

Policymakers must think coherently about the joint implications of their actions, from sanctions on Russia to subsidies and transfers to their own citizens, and avoid taking measures that contradict each other. This is what we try to do in this Policy Contribution, focusing on the macroeconomic aspects of relevance for Europe.

By: Olivier Blanchard and Jean Pisani-Ferry Topic: European governance, Macroeconomic policy Date: April 29, 2022
Read article Download PDF More on this topic
 

Working Paper

The low productivity of European firms: how can policies enhance the allocation of resources?

A summary of the most important policy lessons from research undertaken in the MICROPROD project work package 4, related to the allocation of the factors of production, with a special focus on the weak dynamism of European small and medium-sized enterprises (SMEs).

By: Grégory Claeys, Marie Le Mouel and Giovanni Sgaravatti Topic: Macroeconomic policy Date: April 25, 2022
Read article More on this topic
 

External Publication

What drives implementation of the European Union’s policy recommendations to its member countries?

Article published in the Journal of Economic Policy Reform.

By: Konstantinos Efstathiou and Guntram B. Wolff Topic: Macroeconomic policy Date: April 13, 2022
Read article Download PDF More on this topic More by this author
 

Working Paper

Measuring the intangible economy to address policy challenges

The purpose of the first work package of the MICROPROD project was to improve the firm-level data infrastructure, expand the measurement of intangible assets and enable cross-country analyses of these productivity trends.

By: Marie Le Mouel Topic: Macroeconomic policy Date: April 11, 2022
Read about event More on this topic
 

Past Event

Past Event

Macroeconomic and financial stability in changing times: conversation with Andrew Bailey

Guntram Wolff will be joined in conversation by Andrew Bailey, Governor of the Bank of England.

Speakers: Andrew Bailey and Guntram B. Wolff Topic: Macroeconomic policy Date: March 28, 2022
Read article
 

Opinion

European governance

How to reconcile increased green public investment needs with fiscal consolidation

The EU’s ambitious emissions reduction targets will require a major increase in green investments. This column considers options for increasing public green investment when major consolidations are needed after the fiscal support provided during the pandemic. The authors make the case for a green golden rule allowing green investment to be funded by deficits that would not count in the fiscal rules. Concerns about ‘greenwashing’ could be addressed through a narrow definition of green investments and strong institutional scrutiny, while countries with debt sustainability concerns could initially rely only on NGEU for their green investment.

By: Zsolt Darvas and Guntram B. Wolff Topic: European governance, Green economy, Macroeconomic policy Date: March 8, 2022
Read article More on this topic More by this author
 

Opinion

The week inflation became entrenched

The events that have unfolded since 24 February have solved one dispute: inflation is no longer temporary.

By: Maria Demertzis Topic: Macroeconomic policy Date: March 8, 2022
Load more posts