Has austerity gone too far?

Giancarlo Corsetti, Gernot Müller

Numerous countries faced with debt problems have recently embarked on fiscal tightening. Yet it is not clear if this is a cure or a self-defeating strategy. This column argues that, where sovereign risk is high, fiscal tightening remains an important avenue to bring down deficits at a limited cost to economic activity.

Numerous industrial countries, especially in Europe, have recently embarked on fiscal tightening. The measures adopted so far have not proved a cure-all for financial market concerns about debt sustainability. Tighter fiscal policy has, however, coincided with renewed economic slowdown or even contraction. Against this backdrop, the ranks of commentators who view austerity as potentially self-defeating have swollen. Paul Krugman (2012) and Carlo Cottarelli (2012), for example, argue that the weak output growth caused by fiscal austerity may itself fuel market doubts about government solvency. Higher funding costs, combined with lower activity, might thus worsen the fiscal position, defeating the very purpose of the initial tightening measures.

So should governments relent in their efforts to reduce deficits and restore safer fiscal positions? Drawing on the formal analysis in a recent paper of ours (Corsetti et al. 2012), we argue that this may not be the right conclusion. Although each country needs to be judged on its own specific circumstances, there are sound arguments for fiscal austerity under certain conditions.

A brief overview of recent fiscal thinking

It is worth beginning with a brief overview of the recent fiscal policy debate. Since the start of the global crisis, that debate has undergone several distinct phases. The first phase was dominated by a call for fiscal stimulus to avoid another Great Depression. Then, from 2010 onward, the focus shifted to fiscal consolidation, as high public debt started to loom large. This policy shift occurred despite a global economy that was not yet on a firm recovery path and monetary policy at or near the zero lower bound in many countries. Most recently, calls for austerity appear to have fallen out of fashion again.

When monetary policy is constrained in supporting aggregate demand, credible governments should ideally abstain from immediate fiscal tightening, while committing to future deficit reduction (a point discussed by Corsetti et al. 2010). The key problem in practice, however, is credibility. Faced with nervous financial markets, many governments have opted for upfront tightening. Promising future austerity alone was not seen as sufficiently effective.

Three points the debate on fiscal policy should not miss

Not surprisingly, recent fiscal contractions did not result in a rebound of growth. Indeed, we agree there is little empirical evidence to suggest that expansionary fiscal contractions are common. That said, there is equally little evidence to suggest that fiscal policy is on the wrong side of the Laffer curve, where tighter policies would increase the deficit. In this context, our recent paper highlights the fundamental importance of sovereign risk for macroeconomic stability. The root of the problem is the “sovereign-risk channel”, that is, the tendency of sovereign risk to adversely affect borrowing conditions in the broader economy. It has three implications.

Fiscal multipliers are lower than usual if sovereign risk is high

The presence of a sovereign-risk channel changes the transmission of fiscal and monetary policy, particularly so when the latter is constrained (because, for example, policy rates are at the zero lower bound, or because the economy operates under fixed exchange rates). When sovereign risk is high, a given change in government spending causes a smaller change in output than in normal times. The reason is the offsetting impact from sovereign risk premia, which in our model respond to the health of public finances. Under extreme conditions, the multiplier could even turn negative. Typically, however, consolidations will be contractionary in the short run. Yet, self-defeating consolidations are also unlikely, as multipliers are generally small.

Procyclical fiscal policy may help to ensure macroeconomic stability

Due to the sovereign-risk channel, highly indebted economies become vulnerable to self-fulfilling economic fluctuations. In particular, an anticipated fall in output generates expectations of a deteriorating fiscal budget, causing markets to charge a higher risk premium on government debt. Through the sovereign-risk channel, this tends to raise private borrowing costs, depressing output and thus validating the initial pessimistic expectation.

Under such conditions, a procyclical cut in public spending can stem the possibility of a confidence crisis, by limiting the anticipated deterioration of the budget associated with output contractions. This suggests that highly indebted countries may be well-advised to tighten fiscal policies early, even if the beneficial effect of such action – prevention of a damaging crisis of confidence – will naturally be unobservable. From a probabilistic perspective, even a relatively unlikely negative outcome may be worth buying insurance against if its consequences are sufficiently momentous.

Beyond austerity

To be sure, the near-term output costs of fiscal austerity make it worthwhile to keep thinking about alternative strategies. One such example is making commitments to future tightening more credible, for instance, through legislation on entitlement programs with long-term consequences for the fiscal deficit.

Our work on the sovereign-risk channel also suggests focusing on ways to limit the transmission of sovereign risk into private-sector borrowing conditions. Strongly capitalised banks are one key element in this regard. The ongoing efforts, coordinated by the European Banking Authority, to create extra capital buffers in European banks correspond to this logic. Another element is the attempt by monetary policymakers to offset higher sovereign risk premia. Normally, the scope to do this is exhausted when the policy rate hits the lower bound. Recent unconventional steps by the ECB, however, suggest that more is possible. The extension of three-year loans to banks, in particular, appears to have reduced funding strains, with positive knock-on effects for government bond markets.

Conclusion

In sum, weak growth in countries facing precarious fiscal positions is not sufficient evidence against fiscal austerity. Where sovereign risk is high, fiscal tightening remains an important avenue to bring down deficits at a limited cost to economic activity, as risk premia recede over time. In addition, fiscal austerity may well have important unobserved benefits, by preventing greater macroeconomic instability which tends to arise in the presence of high sovereign risk. That said, our analysis also suggests that policymakers should explore other ways to contain sovereign risk premia, or at least reduce their impact on broader economic conditions.

References

Cottarelli, Carlo (2012), "Fiscal Adjustment: too much of a good thing?", VoxEU.org, February 8.

Corsetti, Giancarlo, Keith Kuester, André Meier and Gernot Müller (2010), "Debt consolidation and fiscal stabilization of deep recessions", American Economic Review: P&P 100, 41–45, May 2010.

Corsetti, Giancarlo, Keith Kuester, André Meier and Gernot Müller (2012), "Sovereign risk, fiscal policy and macroeconomic stability", IMF Working paper 12/33.

Krugman, Paul (2012), "El desastre de la austeridad", El Pais, January 31, 2012

