The IMF put out a paper, recently summarized by The Economist as Does fiscal austerity boost short-term growth? A new IMF paper thinks not.
But is it right to claim, as Mr Trichet and other devotees of “expansionary fiscal consolidations” do, that belt-tightening can actually aid growth in the short term? The intellectual backing for these claims comes from a study by two Harvard economists, Alberto Alesina and Silvia Ardagna, which studied past fiscal adjustments in rich countries. They found that, more often than not, fiscal adjustments that relied on spending cuts boosted growth, even in the very short run. But a new study by economists at the IMF reckons that the Harvard study was seriously flawed.
In particular the fund criticises the way Mr Alesina and Ms Ardagna identified periods of deficit-cutting. The Harvard economists defined major fiscal adjustments as episodes during which the cyclically adjusted primary fiscal balance (CAPB) improved by at least 1.5% of GDP. The IMF argues that movements in the CAPB can give a misleading impression about changes in a country’s fiscal stance…
Back in August Arjun Jayadev and I wrote a Roosevelt Institute working paper: The Boom Not The Slump: The Right Time For Austerity that came to many of the same conclusions about how flawed the Alesina and Ardagna work was. From our paper:
A & A filter this data to find episodes of fiscal adjustment by capturing years in which the primary deficit decreased by at least 1.5 percent of GDP. This leaves them with 107 periods of fiscal adjustment. Such an approach contrasts with the narrative approaches taken by Romer and Romer (2007) that were meant to control for the endogeneity of when to reduce the deficit. These are abrupt changes in GDP, but whether or not the primary deficit is being decreased at the height of a boom or at the bo␣om of a slump remains out of the picture. As we will see, cutting at the height of a boom characterizes many of their results, and as such is not relevant for the current United States.
Table 1 below provides such an examination, using their 26 episodes. The third column gives the growth rate in the year of the fiscal adjustment. The fourth column gives the growth rate in the preceding year. The first thing to note is that the average real growth rate in the year preceding is 4.1% across all episodes. In other words, their examples of successful consolidation were, on average, growing strongly the year before the year of adjustment. This is, of course, unlike the U.S. case today because the country was in recession last year.
To be frank, when I dug into the Alesina and Ardagna paper and finally understood the work their 1.5% primary deficit reduction was doing I wandered around stunned for a day or two. I called a bunch of people I trusted on macroeconomics and tried to see if I was missing something; was our elite discourse, the Sensible People Stuff, really being driven by this?
The IMF continued with their analysis. Here’s what they found, as summarized by The Economist:
Using this method, the IMF reckons that on average a rich country attempted a fiscal contraction of more than 1.5% of GDP about once a decade. (There were also many smaller consolidations; see left-hand chart.) It finds that the typical such episode is clearly contractionary: a fiscal consolidation equivalent to 1% of GDP leads on average to a 0.5% decline in GDP after two years, and to an increase of 0.3 percentage points in the unemployment rate. Spending cuts do less damage than tax rises. This is mainly because they seem to be associated with bigger declines in interest rates. The fund’s economists reckon that this may be because central banks view spending cuts as a stronger signal of a commitment to fiscal prudence and so are more willing to provide some monetary stimulus to soften the blow.
Indeed, declines in interest rates, which also weakened countries’ exchange rates, help explain why GDP did not decline even more sharply. The short-term policy interest rate fell by an average of about 20 basis points for a fiscal consolidation worth 1% of GDP. A rise in net exports due to a real depreciation also helped cushion the blow, although not enough to overcome falls in domestic consumption and investment (see right-hand chart).
[Without these mitigating factors] GDP can be expected to decline by 1%, rather than the historic average of 0.5%. If, in addition, everyone else is cutting, the effect of a fiscal contraction is further magnified. Most people believe that fiscal consolidations are helpful in the long run. Expecting them to be painless looks like wishful thinking.
Their full paper, Will it hurt? Macroeconomic effects of fiscal consolidation, is worth your time if you find this interesting.
What we found when we dug into the OECD data was that you can cut your way out of a recession as long as you can lower interest rates. Or export your way out of the recession. Or if you are comfortable blowing up your debt-to-GDP ratio. Or if you let unemployment skyrocket further. Or if you are a really small country. The big two are interest rates and exports, and neither are available at the zero bound or in a global recession. And without being able to put this in motion an austerity measure would be very, very ugly. There’s a reason economists and governments know to cut during the upswing and not during a weakened state.
Alesina has a response to the Economist justifying his use of the 1.5% metric and the paper more generally. He notes that “In fact, our definition is more stringent. We define as “expansionary” as an episode in which growth is not only above average, but also it is in the top 25 per cent of the sample.”
Jayadev and I wrote about this oddly relative top 25% filter in our paper: “They identify the top 25% of the difference between these two growth rates as periods of ‘expansionary fiscal adjustments’. Note here that an expansion is doubly relative. First, an episode is expansionary if it is in the top quartile of the comparisons being made. But the economy need not be growing quickly (or indeed at all) for this to happen. Second, a country may be growing more slowly or even contracting in the three-year period (inclusive) following the year of adjustment and be considered expansionary if it is growing at a rate that is quicker than the G7 growth rate. This unusual definition selects 26 episodes in which fiscal consolidation takes place and terms them “expansionary.””