Current efforts at fiscal consolidation are unlikely to raise economic growth, according to research by Huixin Bi, Eric Leeper and Campbell Leith, published in the February 2013 issue of the Economic Journal. Their study shows that an expansionary fiscal consolidation is conceivable in a very particular set of conditions – but these conditions are unlikely to be fulfilled in the foreseeable future.
What”s more, the researchers conclude, even if it were possible to engineer the conditions for an expansionary fiscal consolidation, it is unlikely to be a good thing. The policy relies on depressing the economy by leading households and firms to believe that one debt reduction strategy will be followed, only to induce a boom by implementing a different, less costly, policy. In other words, it works by fooling people, which is rarely desirable. Debt reduction is, inevitably, a long and painful process.
The financial crisis of that began in 2007 left advanced economies with average levels of gross government debt breaching 100% of GDP for the first time since the aftermath of World War II. Most governments have sought to place their fiscal policies on sustainable paths by adopting fiscal consolidation programmes.
Textbook analyses of government spending cuts and tax increases suggest that such efforts to reduce government debt will inevitably depress the economy. But there is a body of empirical research that raises the tantalising prospect of an ”expansionary fiscal consolidation”, where the economy actually expands following such policies.
Some politicians have seized on the possibility of expansionary fiscal consolidation. In the UK, for example, Chancellor George Osborne argued that his ”emergency budget” of May 2010 would ”stimulate economic growth and confidence”.
This study attempts to identify the conditions under which an expansionary fiscal consolidation may occur. The researchers conclude that these conditions are unlikely to be fulfilled in the foreseeable future: fiscal consolidation efforts currently in progress are unlikely to raise economic growth.
A very particular set of conditions must be in place to generate an expansionary fiscal consolidation, according to the analysis. If any one of these conditions is not fulfilled, then a consolidation will not grow the economy in the short run:
· The first condition is that as debt levels rise, people come to expect that a fiscal consolidation is imminent.
· The second condition requires that consumers and firms anticipate that the fiscal consolidation will be based on higher taxes rather than lower government spending, but the adopted policy surprises people and turns out to rely more on spending cuts than tax increases.
· The third condition requires that the central bank supports the fiscal consolidation by relaxing monetary policy.
While the first condition seems reasonable – everyone realises that we live in an age of austerity – the remaining conditions are not. Historically, fiscal consolidations were often based on tax increases so that the data used in empirical analyses are likely to contain episodes where governments unexpectedly cut spending rather than raised taxes.
In contrast, an International Monetary Fund (IMF) report on current fiscal consolidation efforts in 12 economies finds that these are all predominantly based on spending cuts rather than tax increases. Organisations like the IMF have also been advising countries to base debt reduction strategies on spending cuts before tax increases – advice that politicians who are increasingly reluctant to raise taxes have not resisted.
Given the political environment, it seems unlikely that people will incorrectly expect policy-makers to return to debt reduction strategies based more on tax increases than spending cuts.
Even if consumers and firms did systematically misjudge the likely composition of the consolidation, the third condition is also unlikely to be met. Monetary policy in the advanced economies is currently stuck at the zero lower bound: central banks simply cannot cut interest rates in support of fiscal consolidation efforts.
Even if they could, countries like the UK are seeing inflation staying stubbornly above the official inflation target (partly in response to the inflationary consequences of changes in tax policy), making it unlikely that central banks will ease further.
In sum, the researchers do not see conditions being ripe for a fiscal consolidation to expand economic activity.
”Uncertain Fiscal Consolidations” by Huixin Bi, Eric Leeper and Campbell Leith is published in the February 2013 issue of the Economic Journal. Huixin Bi is at the Bank of Canada. Eric Leeper is at Indiana University and Monash University. Campbell Leith is at the University of Glasgow.
University of Glasgow | Campbell.Leith@glasgow.ac.uk