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.