The fallacy of austerity-based fiscal consolidation

Posted by Anis Chowdhury on 19 July 2010

The fallacy of austerity-based fiscal consolidation

 

Anis Chowdhury and Iyanatul Islam[1]

 

With the Greek tragedy, fiscal consolidation seems to be the cry of the day, at least in Europe and as reflected in the communiqué of the recently concluded G20 Summit in Toronto. Fiscal consolidation in the US during the Clinton years, Denmark (1983-87) and Ireland (1987-89) and the relative prosperity that ensued, led many to believe that it is possible to achieve fiscal consolidation without harming growth and employment prospect. Thus, the tide has turned against a very brief period when “we were all Keynesians” that helped avert the world economy sliding into a deep depression.

 

In our previous commentaries,[2] we have highlighted the weaker theoretical rationale and doubtful empirical bases for the fear of government deficits and public debts. Here, we look at the often cited examples of successful fiscal consolidation with growth during the Clinton era in the US and two European cases in Denmark and Ireland in the 1980s.

 

It is worth reiterating Domar’s key message that fiscal sustainability crucially hinges on economic growth. Thus, we should distinguish between “growth-based consolidation” and “austerity”, or “thrift-based consolidation”.[3] In a situation of uncertainty about the global economy, and when the private sector is repairing balance-sheets after a long period of debt financed consumption, thrift-based fiscal consolidation will most likely lead to an outcome similar to the “paradox of thrift”, whereby people end up saving less as their incomes decline due to cuts in spending by all in a bid to save more.

 

How does austerity-based fiscal consolidation work?

 

The proponents of “expansionary fiscal contractions” argue that even the supposedly short-run damage of fiscal austerity would be limited or not arise at all; instead, recovery should follow very soon — if consolidations are credible, decisive, and of the right kind. The best articulation of this idea can be found in the “Stability and Growth Pact” of the European Union.

Upholding trust in the soundness of public finances enhances confidence among all economic agents and thereby contributes to sustainable growth in consumption and investment. Stability and growth are thus not conflicting objectives, but rather reinforce each other—a fact which is very well captured in the title of the fiscal framework called the “Stability and Growth Pact” (ECB Bulletin, November, 2003, p. 6).

 

The same message has been echoed in the recent G20 communiqué. It acknowledges the stabilizing role of fiscal deficits, but only in exceptional situations. However, consolidation takes priority over stabilization, and hence, automatic stabilizers must be switched off as soon as possible to avoid any damage to “credibility”. This is supposed to inspire the “confidence” of bond investors to offset any contractionary impact of public expenditure cuts or increased taxes. This is especially important for countries facing acute debt problems, with very high debt ratios together with the prospect of soaring debt service burdens, threatening crowding out and adverse confidence effects.

 

The key link here is between debt costs and bond market confidence, and thus differs from the neo-Ricardian equivalence idea or hopes for positive “supply-side effects” from shrinking public spending. Therefore, fiscal consolidation could be expansionary since cuts in government spending should strengthen the expectation of permanently lower taxes and lower interest rates, which should, in turn,  increase both current consumption and investment. In the most favourable case of austerity-based fiscal consolidation, non-Keynesian effects (from greater credibility and investor confidence) exceed contractionary Keynesian effects of reduced public spending, resulting in higher growth.

 

Additionally, fiscal discipline is seen as a safeguard protecting monetary policy from political pressures. Complementing central bankers’ “independence”, a prudent fiscal framework is expected to help maintain price stability. In sum, deliberate reversal of fiscal trends, brought about by means of redesigned macroeconomic policies and institutions, is believed to positively impact on business expectations and investment to deliver economic growth and employment. Thus, important links are believed to exist involving fiscal consolidation, fiscal and monetary institutions, and economic growth and employment.

 

Growth-based fiscal consolidation

Clinton success

Fiscal consolidation during the Clinton era is the best recent example of growth-based fiscal consolidation. The strong dollar policy and lower interest rates were the prime movers behind the Clinton era expansion, which in turn increased revenue and reduced social security expenditure, and thereby achieving a fiscal surplus.[4] Expansionary monetary policy, in particular, triggered and sustained growth, while fiscal consolidation was a consequence.

 

Then Treasury Under-Secretary, Summers argued against the earlier weak dollar policy to promote growth through exports for at least two reasons. First was the time lag that it takes for exports to rise and imports to fall in response to depreciations – the so-called J-curve effect. Second, in a world of increased capital mobility, any perception of a fall in dollar has to be matched by a corresponding rise in interest rates (due to the arbitrage condition known as interest parity). The higher interest rates associated with a weaker dollar, thus stifle growth while export growth lags.

 

New Secretary of Treasury, Rubin with his years of experience with financial markets, saw the merits of Summers’ argument. In his confirmation hearings before the Senate Finance committee, Rubin stated that a strong dollar was in the best interest of the U.S. economy and warned that the exchange rate should not be an instrument of U.S. trade policy. At a prime-time news conference on 19 April, 1995 President Clinton stated that the U.S. “wants a strong dollar” and that it “has an interest over the long run in a strong currency.” This change of exchange rate policy saw the rise of index value of US dollar against major currencies from less than 80 in January 1995 to over 100 by January 2000.[5]

 

A strong US dollar also meant less imported inflation, allowing the Fed to maintain expansionary monetary policy. The Fed refrained from aborting the long boom of the 1990s by raising interest rates even though unemployment fell markedly below any previous conventional NAIRU measure. In addition to boosting growth, low interest rates helped keep bond yields close to the nominal GDP growth, so that the interest burden stayed under control, as reflected in stability of primary balances close to zero.

 

Thus, the Clinton Administration managed to consolidate the US fiscal position not through any so-called expansionary fiscal contraction. The US experience illustrates the effective use of decisively countercyclical macroeconomic policies that allowed growth-based fiscal consolidation. Growth was not caused by thrift. It was expansionary monetary policy, in particular, that ignited and sustained growth, allowing fiscal consolidation. In large part, fiscal consolidation during the Clinton era was a consequence of the economic boom itself.

 

As documented by Stiglitz, a good part of the dotcom boom was due to the stock market bubble. Increasing private sector debt and unrealistic expectations about future earnings, rather than the expectation of permanently lower taxes, fuelled the surge in consumption and investment.  A number of authors have also observed that the “new economy” boom not only came with much corporate debt, but plenty of household debt too; as the households' saving rate plunged to historic lows and the private sector debt ratio attained new heights.[6]

 

Danish and Irish story

 

Denmark’s (1983-87) and Ireland’s (1987-89) successful consolidations are widely seen as proving the dominance of non-Keynesian effects and the possibility of “expansionary fiscal contractions.” However, Denmark had to live through a long period of sluggish growth from 1987 until 1993, following its supposedly expansionary fiscal contraction of 1983-87. Domestic demand shrank in 6 of 7 years, turning a current account deficit of 5.3% of GDP in 1986 to a surplus of 2.8% in 1993. Since 1994, domestic demand recovered as the real interest rate began declining and converged the EU25 area rate. The Danish central bank not only followed all of the interest rate changes made by the ECB, it also implemented several interest rate cuts independently, thus supporting GDP growth. This easing of monetary policy was possible due to the stability of the exchange rate, which remained within the fluctuation bands defined in ERM II. Denmark embarked on fiscal consolidation in 1996 and, in 2003, only after growth had returned.

 

Likewise, Ireland’s fiscal tightening of 1987-89 was followed by a sharp fall in GDP growth; the Irish resurgence took off in earnest in 1994 (after a second dip recession in 1993). The move to wider ERM exchange rate bands in August 1993 and the commitment to EMU were successful in removing the pressure on exchange rates and its implications for interest rates. The more stable exchange rate environment allowed interest rates to fall and converge the German levels, which helped boost domestic demand and investment.[7]  It seems that the contraction of the Irish economy by over 7% in 2009, following its severe austerity measures is a replay of its earlier experience. Instead of being rewarded for its actions, taken long before the Greek drama unfolded, investors seem to have punished Ireland. The factors that contributed to Ireland’s exceptional growth performance in the 1990s included interest rate convergence, massive EU transfers and foreign direct investment, not so-called investor confidence. Thus, not thriftiness, but investment and growth characterized the Irish miracle.

 

Thus, like the US story of Clinton era, the Danish-Irish growth since the mid-1990s was the result of favourable exchange rate and interest policies, which, in turn, helped fiscal consolidation. A close scrutiny of the Danish-Irish cases would also show that both economies were helped by favourable world economic environment through buoyant export demand and direct foreign investment. This fundamental point is often missed in conventional analysis. For instance, analyzing a large number of mainly small countries’ consolidation experiences the IMF (1996, 58) observes that “good timing in relation to the world business cycle helps.”[8]

 

Concluding remarks

 

The world is a closed economy. When every other country is facing the prospect of a growth slowdown or outright recession, no major economy can depend on exports to compensate for cuts in domestic expenditure.  Large economies are also closed enough, in the sense that their own growth depends on domestic demand, rather than external growth. Investor confidence works in a symmetric  and pro-cyclical way – it rising with a booming economy and falling when the economy is in a downtrun.

 

Therefore, austerity-based fiscal consolidation is a risky bet. It is unlikely to yield investor confidence when unemployment continues to rise. It is not possible to re-create the US boom of the 1990s. No one wants to return to the financial market excesses, and the policy environment is radically different now. The weak Dollar policy seems back again as an instrument of trade policy, and interest rates are at historically low levels. Interest rates can only rise from here on and monetary policy will not be able to offset the contractionary effects of tighter fiscal policy. Fiscal consolidation is only possible when economic recovery gains tractions; at least this is what history tells us.

 



[1] Anis Chowdhury, UN-DESA, New York and University of Western Sydney, Australia; Iyanatul Islam, ILO, Geneva and Griffith University, 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] “Fiscal consolidation, growth and employment: what do we know?”  June 21, 2010, http://www.voxeu.org/index.php?q=node/5216

“Fiscal deficits – the myth of debt and inflation”, Oct. 19, 2009, http://www.voxeu.org/index.php?q=node/4110

“Crisis: Should we worry too much about fiscal deficits?”, Sept. 21, 2009, http://www.voxeu.org/index.php?q=node/4005

[3] Domar, E. D. (1944) “The ‘Burden of the Debt’ and the National Income.” American Economic

Review 34(4): 798-827.

Domar, E. D. (1993) “On Deficits and Debt.” American Journal of Economics and Sociology,

52(4): 475-8.

[4] President Clinton was also able to fend off pressure to increase spending when surplus did emerge in 1998 with the successful slogan, “Save Social Security First.” The policy was at least “let’s save the surpluses until we put social security on a firm footing”—no tax cuts, no big spending increases. For the political economy explanation, see Berglund, Per Gunnar and Matias Vernengo (2004), “A Debate on the Deficit” Challenge/November–December

[5] See, DeLong, J. Bradford and Barry Eichengreen (2001), “Between Meltdown and Moral Hazard: The International Monetary and Financial Policies of the Clinton Administration”, Conference on the Economic Policies of the Clinton Administration, Kennedy School of Government, 26-29 June.

[6] See, for example, Godley, W. (2003) “The U.S. Economy: A Changing Strategic Predicament.” Strategic Analysis,

the Levy Economics Institute; Godley, Wynne  and Alex Izurieta (2003) “Coasting on the Lending Bubble: Both in the U.K. and in the U.S.” Paper presented at the Annual Meeting of the Society of Business Economists, London, June 25, http://www.cerf.cam.ac.uk/publications/files/WA_LendingBb_Jun03.pdf; Godley, Wynne  and Bill Martin, (1999) “How Negative Can U.S. Saving Get?” Policy Note 1999/1, the Levy Economics Institute and Godley, Wynne and  Randall Wray (1999) “Can Goldilocks Survive?” Policy Note, 99/4, the Levy Economics Institute

[7] Murphy, Antoin E. (2000), “The Celtic Tiger – An Analysis of Ireland’s Growth Performance”, European University Institute Working Paper, RSC No 2000/16

[8] IMF (1996) “Fiscal Challenges Facing Industrial Countries.” World Economic Outlook, May