MOST people, among them the tens of thousands of workers who rallied in Brussels on September 29th, believe that fiscal austerity leads to a shrinking economy, at least in the short run. Jean-Claude Trichet, president of the European Central Bank, disagrees. In June he said that “the idea that austerity measures could trigger stagnation is incorrect.” Arguing that a credible fiscal-consolidation plan would restore confidence, he said: “I firmly believe that in the current circumstances, confidence-inspiring policies will foster and not hamper economic recovery.”

With rich-world budget deficits averaging about 9% of GDP in 2009—up from only 1% in 2007—and their average public-debt-to-GDP ratio expected to hit 100% by the end of this year, austerity is a bullet that few rich countries will be able to dodge. 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**.

Austerity can have some short-term benefits. Imagine, for example, that consumer demand is depressed in part because people fear the prospect of a wrenching fiscal adjustment. Devising a credible austerity package could lead people to regard their economic future with less trepidation. This increased optimism may encourage people to spend more freely even in the short run. But are such benefits large enough to ensure that the net effect of fiscal consolidation is to boost growth? The IMF's conclusion is that they are not.

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. For instance, Ireland implemented sharp spending cuts and tax hikes amounting to 4.5% of GDP in 2009. But a collapse in house prices meant that its primary deficit actually worsened. The method used in the Harvard study would not count this as a case of fiscal tightening. By the same token, in Japan in 1998 the government made a one-time capital transfer amounting to 4.8% of GDP to the railways, worsening its budget balance for that year alone. The CAPB improved sharply in 1999 without the government needing to implement any austerity measures, yet the Harvard study would count this as a fiscal adjustment. The fund argues that omitting cases like the Irish one (which was associated with a decline in growth) and mistakenly counting instances like Japan's in 1999 (when growth did not decline) reduces the Harvard study's ability to pick up the growth-retarding effects of actual fiscal contractions.

The fund espouses a different method of identifying cases of belt-tightening. It argues that any year when the government implemented deficit-reduction measures of a certain scale ought to count as a fiscal adjustment, even if other shocks may have meant that the eventual change in the deficit was not as large as intended. The fund's economists return to its records of countries' fiscal policies to identify years when the government raised taxes or cut spending in order to tame the deficit. In other words, it looks at intent and action rather than outcomes.

Austerity costed

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).

At the moment, however, there is less scope for these mitigating factors. Interest rates in most rich countries cannot fall much further. And a country cutting its deficit now would not be doing so alone (which would reduce the impact on exports). Simulations carried out by the fund show that slashing spending in an environment where interest rates have no more room to fall doubles the contractionary effect of such cuts compared with a situation where the central bank still has scope to cut rates. In such a situation, 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.





* “Large Changes in Fiscal Policy: Taxes Versus Spending”, by Alberto Alesina and Silvia Ardagna. NBER Working Paper No. 15438, revised January 2010



** “Will It Hurt? Macroeconomic Effects of Fiscal Consolidation”. Chapter 3 of the IMF's October 2010 “World Economic Outlook”