Fiscal consolidation, growth and employment: what do we know?

Fiscal consolidation, growth and employment: what do we know?


Iyanatul Islam and Anis Chowdhury[1]




The Great Recession of 2008-2009 triggered the enactment of expansionary policies in both developed and developing countries to combat the sharp decline in aggregate demand across the world.[2] Key international institutions, ranging from the IMF to the OECD, all became Keynesians and urged national policy-makers to adopt and sustain fiscal interventions and historically low policy interest rates throughout 2009 to stave off a depression. The verdict seems to be that expansionary policies staved off a depression, but could not avoid rather deleterious unemployment outcomes in developed countries and at least a transient increase in poverty in many developing countries.[3]


The Keynesian moment did not last very long. Some leading economists have decided to bid ‘farewell to Keynes’.[4] The policy discourse, most notably in the rich nations, is that governments must now engage in fiscal consolidation and bring back public finances - wrecked by recession-induced declines in revenues and increased spending commitments - to sustainable levels. As the Economist observes: ‘Across much of the rich world an era of budgetary austerity beckons.’[5] But signs of ‘budgetary austerity’ also seem to be emerging in a sizeable number of low and middle-income countries. One study finds that, in a sample of 86 low and middle income countries, about 40 per cent are engaging in reductions in public expenditure in 2010-2011 relative to 2008-2009. The average projected spending cuts are around 2.6 per cent of GDP.[6]

What should be the scale of the fiscal adjustments? Is it possible to have the best of both worlds, that is, a combination of successful fiscal retrenchments, no output and employment loss or, better still, growth and employment creation? We briefly review the relevant issues and evidence and conclude that neither current global economic circumstances nor historical experiences allow us to be confident about the scale of fiscal adjustments that have been proposed and the growth promoting capacity of such adjustments.


Fiscal consolidation: how much and with what consequences?


The standard view, enshrined in the Maastricht Treaty, is that for a rich economy a 60% debt-to-GDP ratio is considered to be prudent. Currently, the projected debt-to-GDP ratio among the advanced economies of the G-20 will reach 118% by 2014. These are the scenarios used by the IMF to suggest that governments in the developed world need to improve their budget balances by about 8 per cent of GDP by 2020. Such an adjustment will enable them to reach the Maastricht Treaty norms by 2030.[7]

The announced plans by several European governments suggest fiscal consolidation measures as a proportion of GDP that range from 10.7 % of GDP (Greece) to 3.0 % of GDP (Germany).[8] It is difficult to ascertain the extent to which such announcements have been influenced by the 60 % target. Of course, this target is arbitrary as it is supported by neither theory nor evidence as a reasonable approximation of an optimal debt-to-GDP ratio. The scale of the fiscal adjustments will be much less draconian if a lower threshold is adopted. Consider, for example, the case of the United States. If the government wishes to stabilize the debt-to GDP ratio as it prevails at 2010, then the primary deficit should be around 1% of GDP. On the other hand, if it wishes to reach the 60% target, then the primary balance will have to move to a surplus of 4% of GDP by 2020 and maintained at that level for another decade. Hence, it follows that the scale of the fiscal adjustments that is being prescribed by some international institutions relies on benchmarks that have been mechanically derived.[9]

Fiscal austerity measures are, of course, worthwhile if they have growth promoting effects or, at the very least, they do not lead to a net decline in aggregate demand. Do they?  Neoclassical proponents of fiscal consolidation typically focus on the so-called ‘Ricardian equivalence’ and the ‘crowding out’ thesis to make their case. The Ricardian equivalence maintains that public sector profligacy can be fully offset by private sector prudence if economic agents correctly anticipate that future tax liabilities will rise as a result of a fiscal expansion. It then follows that the contractionary consequences of a fiscal retrenchment will be offset by an increase in private sector spending as economic agents correctly anticipate a decline in future tax liabilities. The ‘crowding out’ thesis maintains that fiscal expansions lead to a rise in real interest rates thus inducing a decline in private sector spending because of its sensitivity to higher costs of borrowing. The strong version of this thesis suggests that the decline in private sector spending will exceed the increase in aggregate demand induced by the increase in government expenditure. It follows that, under such circumstances, fiscal austerity can boost growth by stimulating private sector spending.

Added to such neoclassical ideas is the thesis of ‘market confidence’ and the role that this psychological factor plays in investment decisions. The standard argument is that financial markets reward fiscal probity. Hence, when governments demonstrate a credible commitment to a fiscal consolidation programme, they are rewarded by reduced ex-ante and ex-post costs of borrowing in the sovereign debt market. This in turn stimulates private capital inflows that augment private domestic investment as a source of growth and employment creation. In the contemporary debate on fiscal consolidation, some commentators have suggested a ‘forward-looking’ interpretation of ‘market confidence’. This implies that governments have to be proactive and anticipate how markets might react in the future by adopting a ‘big bang’ approach to fiscal consolidation. Thus: ‘Given that the current levels of debt are high by historical standards and that they are very high in many advanced economies, it might be that markets will soon ask for a strong signal of commitment and, in its absence, risk premia on government bonds will increase. To avoid an increasing cost of rolling over the debt, governments could be better off with a strong early adjustment’ (emphasis added).[10]

There are thus various channels through which a fiscal consolidation programme can either reach its goal without imposing any output or employment loss or, even better, be accompanied by growth and employment creation. These propositions, while valid in principle and contrary to the basic Keynesian perspective that fiscal retrenchments can induce a recession, ultimately need to be empirically substantiated. Here, the evidence does not support the robust proclamations of the advocates of fiscal consolidation. There is hardly any evidence that fiscal policy multipliers are either zero (as in the case of full Ricardian equivalence) or negative (as in the strong version of the crowding out thesis).  Even the proponents of fiscal consolidation agree that the available evidence suggests that fiscal policy have ‘significant effects’ on output and unemployment and that such effects are ‘likely to be larger during recessions’.[11] Furthermore, there is little evidence that countries, such as the UK and Germany, which seem poised to embark on significant fiscal austerity programmes, are facing an impending increase in risk premia on government bonds.[12]

There is the more fundamental issue of whether the policy-making process should become hostage to the ‘confidence game’ in which evidence-based policy-making is replaced by a band of amateur psychologists seeking to read the collective mood of financial markets. When this happens, fundamental macroeconomic policy errors are likely to be committed, as the mishandling of the 1997 Asian financial crisis by international financial institutions has shown.[13]

Such caveats notwithstanding, a number of cross-country studies have sought to demonstrate using historical data that fiscal consolidation are accompanied by growth and declines in unemployment. Two cases from this genre are worth highlighting. First, an IMF study focused on 74 cases of fiscal consolidation in 20 industrialized countries over the 1970-1995 period.[14] It concludes that 14 cases were ‘successful’ in the sense that they were marked by sustainable reduction (by about three percentage points over a period of three years) in the debt-to-GDP ratio as well as an increase in growth and employment creation. Second, a study by Alesina and Ardagna focused on 107 episodes of fiscal consolidation in all OECD countries for the 1970 to 2007 period.[15] It concludes that 27 could be classified as cases that combined fiscal consolidation with growth. Such results are underwhelming. The historical experience thus suggests that the probability of a successful fiscal consolidation is between 19% (as in the IMF study) and 25% (as in the Alesina-Ardagna study).

Even if one accepts that fiscal consolidation programmes have a reasonable chance of being accompanied by growth and employment creation, one cannot attribute such an outcome to budgetary austerity alone. There are often enabling factors at work that might be more important than fiscal actions. They include: (1) the influence of the global business cycle, (2) monetary policy, (3) exchange rate policy and (4) structural reforms. The aforementioned IMF study found that ‘…strong global economic growth helps to achieve a successful consolidation, and weak global growth reduces the chances that consolidation will cut the debt-to-GDP ratio’. It is also well-known that fiscal retrenchments can be combined with loose monetary policy to offset recessionary consequences. One 2003 European Commission study finds that, in more than 50% of the cases examined, fiscal austerity programmes were accompanied by expansionary monetary policy that enabled growth to be sustained.[16] Similarly, the idea of combining fiscal retrenchments with devaluation that boosts net exports to offset the decline in aggregate demand (so-called ‘expenditure reducing policies’ combined with ‘expenditure switching policies’) is well known. Furthermore, the expansion that accompanies fiscal consolidation might well stem from structural reforms that alleviate binding constraints on growth.

The importance of these enabling factors needs particular attention in light of current circumstances. To start with, the post-crisis economic recovery is still fragile. The rich countries of the world in particular are struggling with weak labour markets and fairly tepid growth. Hence, the regional business cycle is not conducive enough for fiscal consolidation to work. The Eurozone economies also do not have scope for devaluations nor do they have much room to cut interest rates further through expansionary monetary policy as policy rates are still at historically low thresholds.


Concluding remarks


It seems that the results of historical studies of fiscal consolidation exercises suggest a relatively high failure rate. Even in the successful cases, there were enabling factors at play that might have offset the recessionary consequences of fiscal retrenchments. Furthermore, the usual arguments that are invoked to justify fiscal consolidation (Ricardian equivalence, crowding out and market confidence) lack robust empirical substantiation. We conclude by noting that one study has offered some estimates of the net impact of fiscal consolidation on growth in eight European economies (Germany, France, United Kingdom, Italy, Spain, Netherlands, Portugal, Greece). It suggests that, even by 2016, all countries bar one will suffer an output contraction as a result of the transition from fiscal stimulus packages to consolidation.[17] Critics – and there are many – of the looming era of fiscal austerity in the rich world, and perhaps even in developing countries, are justifiably worried.[18]







[1] Iyanatul Islam, ILO, Geneva and Griffith University, Australia. Anis Chowdhury, UN-DESA, New York and University of Western Sydney, Australia. The views expressed here are strictly personal and do not necessarily reflect the views of the United Nations or any of its agencies/funds/programs.

[2] By April 2009, liquidity injections into the financial system and bailouts of some major financial institutions amounted to $18 trillion or almost 30% of world gross product (WGP) and fiscal stimulus packages amounted to about $2.7 trillion or 4% of WGP, to be spent over 2009-2011.

[3] Verick, S and Islam, I (2010) ‘The Great Recession of 2008-2009: Causes, Consequences and Policy Responses’, IZA DP. No. 4934, May 2010. There are various estimates coming from different sources - sometimes from the same source. The initial 2009 World Bank (Press Release, February 12, 2009) suggested that “lower economic growth rates will trap 46 million more people on less than USD1.25 a day than was expected prior to the crisis”. In an ‘op-ed’ written for the New York Times (January 22, 2009), Robert Zoelick, the President of the World Bank, stated ‘…the economic crisis has already pushed an estimated 100 million people back into poverty’.  The World Bank in the latest Global Economic Prospects 2010 revised its estimates of poverty due to the economic/financial crisis to 64 million. The UN’s World Economic Situation and Prospects 2010 suggests that, “in 2009, between 47 and 84 million more people have remained poor or will have fallen into poverty in developing countries and economies in transition than would have been the case had pre-crisis growth continued its course." (p. 10).

[4] Sachs, J (2010) ‘Farewell to Keynes’, Financial Times, June 8

[5] The Economist (2010) ‘Fiscal tightening and growth’, March 31

[6] UNICEF (2010) ‘Prioritizing Expenditures for a Recovery with a Human Face’, Social and Economic Policy Working Briefs, April

[7] IMF (2010) ‘Strategies for Fiscal Consolidation in the Post-Crisis World’, Fiscal Affairs Department, IMF

[8] Broyer, S and Brunner, C (2010) ‘From economic stimulus packages to fiscal consolidation : what net effect on growth?’, June 4- no.283, NATIXIS

[9] 60% was the average debt-to-GDP ratio among prospective members when the European Monetary Union was launched.

[10] Fatas, A (2010) ‘The Economics of Achieving Fiscal Sustainability’, paper presented to Board of Governors, Federal Reserve, April 9

[11] Fatas (op.cit)

[12] Wolf, M (2010) ‘Fear of the markets must not blind us to deflation’s dangers’, Financial Times, June 8

[13] Krugman, P. (2002). The Return of Depression Economics, New York: Penguin Books.

[14] Dermott, C.J and Wescott, R.F (1996) ‘Fiscal Reforms That Work’, Economic Issues, No.4, November, IMF

[15] Alesina, A and Ardagna, S (forthcoming) ‘Large Changes in Fiscal Policy : Taxes vs Spending’ as cited in Fatas (op.cit) and Alesina, A (2010) ‘Fiscal adjustments : lessons from history’, Harvard

University, prepared for the Ecofin meeting in Madrid, April 15

[16] As cited in Posen, A (2005) ‘Don’t Kid Yourself about Fiscal Consolidation’, November 6, Peterson Institute for International Economics

[17]  Broyer and Brunner (op.cit)

[18] A non-exhaustive list includes Bradford De Long, David Blanchflower, Dani Rodrik, Lord Skidelsky, Martin Wolf, Paul Krugman, Wolfgang Munchau, the editors of the Economist and the New York Times.