In the wake of the Great Recession, a contentious debate has erupted over whether fiscal consolidation, less formally known as ‘austerity’, is helpful or harmful for economic growth. One side argues that austerity is expansionary when achieved via spending cuts rather than tax increases (Alesina and Perotti 1995, Alesina and Ardagna 2010). An alternative view, consistent with textbook prescriptions for countercyclical fiscal policy, suggests that fiscal consolidation is harmful to growth when implemented in the midst of a crisis (Blanchard and Leigh 2013). Both camps, however, ignore the wealth of information inherent in comparing the economic performance of countries that pursue fiscal austerity with those that opt for a different path.
In contrast to the previous literature on fiscal adjustment, this is precisely the approach we adopt in a new paper, “Two Tales of Adjustment: East Asian Lessons for European Growth” (Chari and Henry 2015). Roughly a decade apart, East Asia and Europe were each struck by recessions caused by a similar set of factors: excessive lending (especially in real estate) leading to a high incidence of non-performing loans and failure of financial institutions, followed by a severe credit crunch. Leaders of East Asia responded with standard textbook expansionary fiscal policy, while European leaders switched from fiscal expansion to consolidation before their crisis-ridden economies had recovered.
Using a macro case study in the spirit of the policy experiment approach (see Henry 2007, Henry and Miller 2009), we exploit the similarities between the causes of the Asian financial crisis of 1997–1998 and the Global Crisis of 2008–2009 – and the differences in economic policy responses – to provide a setting in which we can more definitively answer the following question: Did the large and abrupt reversal from fiscal stimulus to fiscal consolidation in Europe at a moment when output was still falling cause its post-crisis recovery to be slower and less complete than it would have been in the absence of this policy reversal?
Two crises, two fiscal policy responses
At the onset of the Asian crisis, officials from the International Monetary Fund (IMF) urged Asian governments to pursue fiscal consolidation as a means of improving the current account through a decrease in absorption, thereby stabilising the balance of payments. On the brink of losing capital market access and in desperate need of liquidity, Asian crisis countries complied with the IMF’s prescription in order to receive emergency loans. Shortly after the initial agreements were signed, however, the IMF reversed course with respect to its initial prescription and allowed its East Asian clients to increase their deficits by enabling automatic stabilisers to take hold.
The policy approach in Europe following the Global Crisis was quite different. There, starting in the fall of 2008, the IMF encouraged countries to pursue fiscal stimulus. Two years later European governments changed tack and pivoted to austerity. They reduced budget deficits as a fraction of GDP and announced the European Fiscal Compact in March 2011. Europe’s pivot away from stimulus toward a starkly different policy stance in the midst of a crisis with very similar causes to the one in Asia enables us to view the trajectory of output in Asia as a proxy for what might have happened in the peripheral countries of Greece, Ireland, Italy, Portugal, and Spain (GIIPS) had Europe stayed the course with stimulus.
Two simple graphs – one of the deficit and the other of GDP growth, with both plotted in region-specific event time – illustrate the differing policy responses in Asia and Europe and their attendant consequences for growth. Figure 1 demonstrates that East Asia pursued a relatively neutral to expansionary fiscal policy stance in the midst and immediate aftermath of the crisis. Figure 1 also shows the markedly different approach taken in the European periphery countries (GIIPS). In the GIIPS, structural and primary fiscal balances expanded significantly in 2008 and 2009. Starting in 2010, however, the modus operandi in European economic policy switched from stimulus to austerity. Charting the cyclically adjusted primary balance (not pictured here) reveals a similarly abrupt pattern as the region pivots toward austerity.
Figure 1. Primary fiscal balance in event time
Figure 2 plots the evolution of the growth rate of GDP in affected countries before and after the East Asian and European crises. The two crises caused sharp economic contractions in both East Asia and in the GIIPS. But while the recovery in Asia was a rapid and robust ‘V’-shaped affair, Europe is still struggling to mount a recovery – more of a ‘W’, less the final upstroke. A striking feature of the data is the speed with which growth recovered in East Asia. Within a year of the crisis, GDP growth turned positive. The average growth rate of GDP during the four-year period after the crisis was about 5% – not quite back to the pre-crisis average, but a strong economic performance by most standards.
Figure 2. Real GDP growth in event time
The event-time profile of GDP growth in the GIIPS stands in sharp contrast to the East Asian profile. While output falls on impact and the recession deepens in the first year after the crisis hits, the pace of contraction slows in the second year as GDP growth becomes slightly less negative. But rather than growth continuing to recover as it did in East Asia, the GIIPS economies experience a ‘double dip’, contracting even more sharply in Year 3 and falling to about -2.5% by Year 4. The correspondence between the components of this three-quarter ‘W’ and the evolution of fiscal policy depicted in Figure 1 provides strong prima facie evidence that the so-called double dip was triggered by the large and rapid pivot from stimulus to austerity after Year 2.
Of course there are numerous reasons why these preliminary observations should be interpreted with caution. First, in contrast to the 2008–2009 Global Crisis, the East Asian crisis began in the periphery of the world economy and never fully penetrated the core, so that continuing growth in the advanced economies could act as a buffer to support a quick, export-oriented recovery in Asia. Second, in terms of initial macroeconomic conditions, the East Asian countries had accumulated surpluses by running countercyclical fiscal policy; they had much lower pre-crisis debt-to-GDP ratios and therefore a larger fiscal cushion with which to absorb the impact of their crisis than did European countries at the onset of the Great Recession. Third, in addition to allowing automatic fiscal stabilisers such as the expansion of spending on the social safety net to kick in, the adjustment of prices – specifically the exchange rate – played a central role in the rapid recovery of output in East Asia.
In spite of these caveats, however, our results do provide substantial evidence that fiscal consolidation in Europe exerted a powerful, negative impact on growth. Across the board, t-tests of differences in differences confirm the simple visual story of Figures 1 and 2. T-tests of differences in differences on unemployment are also consistent with the growth results, and all of our results are robust to alternative time frames for the pre- and post-pivot windows. Panel regression estimates that control for country-fixed effects, changes in exchange rates, and differences in debt-to-GDP ratios confirm that the change in fiscal stance from stimulus to austerity had a negative and statistically significant impact on real GDP growth in Europe. In East Asia, the impact of fiscal policy is evident on impact during and following the crisis, and had a statistically significant and positive effect on real GDP growth in the post-crisis period.
Asia’s recovery following its financial crisis was more rapid and robust than Europe’s, and the decision by policymakers in the two regions to adopt very different fiscal strategies provides a leading explanation for why this was the case. Although the impact on growth and employment of Europe’s pivot to austerity could have been exacerbated by the absence of other policy levers such as exchange rate flexibility and monetary policy independence, the data seem to corroborate the wisdom of countercyclical fiscal policy. By running surpluses when times are good, governments can accumulate a stockpile of funding that allows them to spend, stimulate aggregate demand, and cushion the blow when the economy is hit with a negative shock. Comparing the divergent recoveries in Europe and East Asia also yields the conclusion that, in response to similar crises, it is not simply the size of the fiscal stimulus that matters but also its variability and persistence. While cold-turkey deficit reduction may be the optimal strategy for balancing the budget in some circumstances, on other occasions a gradual path toward recovery and eliminating the deficit may constitute the more prudent and productive course of action.
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Blanchard, O and D Leigh (2014), “Learning about Fiscal Multipliers from Growth Forecast Errors”, IMF Economic Review 62: 179–212.
Chari, A and P B Henry (2015), “Two Tales of Adjustment: East Asian Lessons for European Growth”, IMF Economic Review (forthcoming).
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Henry, P B and C Miller (2009), “Institutions versus Policies: A Tale of Two Islands”, American Economic Review 99(2): 261–267.