The Greek debt crisis has become a Eurozone crisis, with no shortage of commentary (see for example Baldwin et al. 2010). Yet is has so far been treated as a Eurozone problem. Fiscal sustainability is a global issue and should be understood in the context of the policy reaction to the global crisis.
This piece emphasises two dimensions of debt consolidation during early phases of the recovery from deep recessions. First is the benefit from credible and steady implementation of spending cuts. Second is the possible cost of deficit-reducing measures when the economy has not yet overcome the financial stress at the root of the crisis. It also emphasises that, especially after 2008, markets’ risk tolerance is near zero. Policy hesitation and mixed signals may have strong undesired consequences.
Three phases in policy strategies
Fiscal consolidation is the third phase in the policy response to the global crisis. In a first phase, spanning the period between 2007 and the summer of 2008, the crisis was viewed as a liquidity problem. Central banks provided assistance and made up for the disappearance of the interbank market; governments provided limited support to failing institutions. This strategy relied on the ability of financial intermediaries to “de-risk”, i.e. clean up their balance sheets. The cost of the crisis, in financial and fiscal terms, was perceived to be relatively contained and thus manageable. Ex post, this strategy proved to be insufficient, if not misguided. Financial intermediaries were reluctant to dilute existing shareholders and did not increase their capital sufficiently. On the contrary, they were allowed to pay out dividends and increase their leverage.
With risks brewing and international markets turning increasingly nervous, a second phase in the policy response to the crisis started in the fall of 2008, when the systemic nature and the true magnitude of the banking problems became apparent. A global panic spread among non-financial firms and households, paralysing investment and spending plans. The necessary shift in policy focus, however, took some time to occur, which arguably amplified the depth of the crisis.
In this second phase, governments complemented liquidity provision with massive guarantees for banks’ debt and assets as well as capital injections into ailing banks, transferring private risk to the budget. Moreover, governments allowed public deficits to increase to the full extent of the economic downturn and implemented some (in the big scheme of things, relatively moderate) stimulus packages. In the context of an international panic, deficit financing was made easier by the “flight to quality” by international investors – especially benefiting countries with a large GDP relative to the liabilities of their financial system, with robust fiscal shoulders, and with a reserve currency.
Whether or not this strategy saved the world from another great depression, its consequences are troublesome by themselves. First, advanced countries saw their public debt rise on average by 20 percentage points so far; another 20 percentage points will be added by 2015 according to recent estimates by the IMF (IMF 2010). Second, the memory from the fall of 2008 led to much lower risk tolerance among investors, who are now ready to flee from entire asset classes upon any sign of trouble. This is clearly a concern for governments in relatively good fiscal shape, and yet with large contingent liabilities from outstanding guarantees to the banking sector. Accordingly, the second phase led to an increasing level of fiscal risk, potentially threatening the recovery from the crisis. Fiscal consolidation is therefore emerging as the core issue defining a third phase of policy interventions.
The recent shift in the tone of the political debate in this respect is somewhat surprising. Everyone could see the growing stock of public liabilities throughout 2009 and early 2010, and easily forecast the need for debt stabilisation measures at some point during the recovery phase. Already in May 2009, André Meier, Gernot Mueller, and I circulated a paper emphasising the potential benefits from recognising the inherent link between successful stimulus measures and the design of feasible consolidation plans relying, to a large extent, on spending cuts (Corsetti et al. 2009).
Stimulus and consolidation policies should not be envisioned as two unrelated policy emergencies. In light of the experience during the crisis, the inability to envision an integrated and comprehensive recovery strategy in different phases is dangerous. Underestimation of financial risk and initial policy hesitation/reluctance in redressing the problems at the core of the crisis have already been quite costly. Similar missteps on fiscal consolidation are now possible.
How should fiscal consolidation proceed? Advantages of steady, gradual implementation of spending cuts
The fact that the world economy is still fragile does not imply that fiscal consolidation should not start right now. Now is indeed the time for undertaking reforms and measures that ensure a sustainable fiscal path over the coming years.
Given the size of the public debt, it is unlikely, and even unwise, that the whole burden of the correction should fall on taxation. On the contrary, successful debt consolidation will depend on government’s ability to cut or at least contain current spending. Using quantitative methods, Keith Kuester, André Meier, Gernot Mueller, and I have carried out some exercises in assessing the macro effects of consolidation via such spending cuts. We study the case of consolidation occurring when the economy is on its way to recover from a recession so deep that policy interest rates are at the zero lower bound (see Corsetti et al. 2010a).
In the model, a gradual implementation of spending cuts has several desirable effects. A gradual implementation of fiscal consolidation effectively allows the central bank to smooth the rise in policy rates when exiting from the zero lower bound constraint, as the economy recovers from the crisis. As this translates into lower real rates over time, anticipation of future spending cuts raises the size of the short-run multipliers from fiscal stimulus during the slump, and shortens the time during which monetary policy is constrained by the lower bound.
Our results are illustrated by the figure reproduced below. In the exercises underlying this figure, we posit a recessionary shock of known duration, which is fought with a persistent increase in public spending. Fiscal expansion is later offset either by higher (non-distortionary) taxes or by a combination of higher taxes and spending cuts that bring public spending below the pre-crisis levels. For the sake of argument, we assume that spending cuts are implemented over four quarters only – hence producing a sharp correction in public liabilities within a limited time span. However, their implementation can be delayed for a few quarters after the end of the stimulus.
The figure plots the impact multiplier of government spending on consumption and output during the crisis (left panel), and the number of quarters in which the economy remains stuck at zero nominal interest rates (right panel), as a function of “if” and “when” the consolidation via spending cuts takes place. A “no” on the x axis refers to a baseline scenario where consolidation takes place only via higher taxes. To start with, observe that the multipliers on consumption and output corresponding to a tax-only scenario are somewhat higher than one and two, respectively, and the economy is stuck at the zero lower bound on policy rates for eight quarters (see also Christiano et al. 2009). Relative to this baseline scenario, a very early implementation of spending cuts (with one quarter delay from the withdrawal of the stimulus) actually reduces multipliers and increases the interval for which the economy is stuck at the zero lower bound. On the contrary, a four-to-eight quarter delay implies higher multipliers and brings the exit from the zero lower bound forward in time. Details are spelled out in Corsetti et al. (2010).
One important caveat is in order. The exercise underlying the figure abstracts from sovereign default risk premia, which clearly matter a lot in today’s economic environment. In ongoing work we allow for the possibility that high public debt sharply raise the interest rate faced by governments as well as the private sector. These risk premia can be expected to raise the benefit from early consolidation. However, preliminary results show that steady but gradual consolidation over time often still emerges as the preferable strategy.
What lessons can we draw from our exercises? First, consolidation is an essential part of the recovery strategy. The short-run effects of expansionary measures cannot be assessed independently of fiscal consolidation plans for the medium and long run. In fact, a reversal of the upfront stimulus measure via future spending cuts enhances the ability of fiscal policy to moderate the initial output contraction and mitigates the “zero lower bound problem”.
Second, successful consolidation measures should be assessed mainly in terms of their effectiveness to produce permanent sizeable relief for the budget. Provided the overall set of announced measures is sufficient to ensure sustainability, the timing of their implementation may make a difference.
In practice what could work best is implementing some deficit-cutting measures upfront (to gain credibility and show resolve), while setting most of the overall required consolidation in train for the (near) future – through credible announcements of pay freezes, reform of benefit schemes, etc. Clearly, talk alone is not enough; concrete legislative steps to ensure future cuts should be coupled with some cuts right away. But excessive front-loading can be problematic if the economy has not sufficiently advanced on the recovery path.
Macroeconomics of fiscal contractions during a financial crisis
A serious risk in front-loading consolidation measures arises from the fact that the world economy is not yet out of the slump. With the financial crisis still in swing, pursuing very aggressive consolidation now may come at a high cost, which is not worth bearing unless financing conditions leave governments little other choice.
In empirical work focused on OECD countries, André Meier, Gernot Mueller and I find that impact multipliers for government spending on goods and services are on average quite low, consistent with a large empirical literature. But they can become much higher – as high as 2 for output and consumption – during financial and banking crises (Corsetti et al. 2010b). We find that unexpected changes in government spending on final goods and services affect output, consumption, and investment much more than one-to-one, conditional on the economy experiencing a “financial and banking crisis” according to the classification of Reinhardt and Rogoff (2008). To be sure, the number of crisis observations in our OECD sample is relatively limited, and the empirical methods we use (identifying fiscal shocks from the residuals of simple fiscal rules) are subject to ongoing controversy, so these estimates should be taken with a pinch of salt. Nonetheless, our results unambiguously point to large differences in the macroeconomic effects of government spending between crisis and non-crisis periods, which appear to be robust to many empirical exercises we perform.
We interpret our results as supporting a strongly precautionary approach to fiscal policy. It is crucial to build buffers in good times precisely for not being forced to contract during bad times, when the cost of a contraction is disproportionately high. In today’s circumstances, this translates into a specific warning about the macroeconomic costs of every extra cut in the deficit, as the financial crisis is not over yet.
Taking the empirical evidence at face value, there is good and bad news. The good news is that, if the economy has overcome the worst part of the financial and banking crisis, the cost of cuts may actually be quite small, even in terms of output. This is reassuring, given the prospect of many years of post-crisis “fiscal austerity”. The bad news is that as long as the financial fragilities and constraints have not been resolved, front-loading cuts in the next few quarters may well endanger the recovery.
Fiscal consolidation in this new phase of the crisis is inescapable. The above considerations suggest that the appropriate strategy be not the same everywhere. Obviously, sharp corrections are needed in countries that already face high and increasing risk premia on their debt. Failure to consolidate would not only raise the cost of borrowing for the government; it would also undermine macroeconomic stability with widespread economic costs. In these cases, immediate cuts in spending and tax hikes may be useful in signalling the government’s commitment to consolidation, even if, other things equal, their short-run costs in terms of output are not negligible (but would be even higher in the absence of correction). Yet it is important to reiterate that the credibility and success of such corrections will not be judged by their capacity to generate a positive cash flow for a few quarters, but on the grounds of their sustainability, and their budget and growth effects, in the medium to long run.
In countries where risk premia remain low, improving the fiscal outlook is no less urgent, but it would be advisable to design consolidation strategies that foresee more steady adjustment. Adopting strongly frontloaded strategies, to signal immediate improvement in fiscal cash flows, can be tempting as an extra insurance against market jitters.
However, under the present circumstances, it is wise to also assess the downside risks very carefully and avoid excessive contractionary effects on aggregate demand, consistent with the overall goal to provide a stable macro environment for households and firms to recover confidence.
Disclaimer: As this text reports result from joint work with André Meier at the IMF and Keith Kuester at the Federal Reserve Bank of Philadelphia, it is appropriate to reiterate the disclaimer included in all our joint papers, that the views expressed here do not necessarily reflect the views of the IMF, or the Federal Reserve System.
Baldwin, Richard, Daniel Gros, and Luc Laeven (eds.) (2010), Completing the Eurozone rescue: What more needs to be done?, A VoxEU.org Publication, 17 June.
Christiano, Lawrence, Martin Eichenbaum, and Sergio Rebelo (2009), “When is the government spending multiplier large?”, NBER Working Paper 15394.
Corsetti, Giancarlo, Andre Meier and Gernot Mueller (2009), “Fiscal Stimulus with Spending Reversals”, CEPR discussion paper 7302.
Corsetti Giancarlo, Keith Kuester, Andre Meier and Gernot Mueller (2010a), “Debt Consolidation and Fiscal Stabilization of Deep Recessions”, American Economic Review, May.
Corsetti Giancarlo, Andre Meier and Gernot Mueller (2010b), “What determines government spending multipliers?”, mimeo.
Intertemporal Monetary Fund (2010), “Navigating the Fiscal Challenges Ahead”, Fiscal Monitor, World Economic and Financial Survey, May
Reinhart Carmen and Kenneth Rogoff (2008), “Banking crises: An equal opportunity menace”, NBER Working Paper 14587.