Austerity Debate a Matter of Degree. By Stephen Fidler
In Europe, Opinions Differ on Depth, Timing of Cuts; International Monetary Fund Has Change of Heart
Wall Street Journal, February 17, 2012
the U.S., the debate about whether the government should start cutting
its budget deficit opens up a deep ideological divide. Many countries in
Europe don't have that luxury.
True, there may be questions
about how hard to cut budgets and how best to time the cuts, but with
government-bond investors going on strike, policy makers either don't
have a choice or feel they don't. Budget austerity is also a recipe
favored by Germany and other euro-zone governments that hold the
Continent's purse strings.
Once upon a time, the International
Monetary Fund, which also provides bailout funds and lend its crisis
management expertise to euro-zone governments, would have been right
there with the Germans: It never handled a financial crisis for which
tough austerity wasn't the prescribed medicine. In Greece, however,
officials say the IMF supported spreading the budget pain over a number
of years rather than concentrating it at the front end.
partly because overpromising the undeliverable hurts government
credibility, which is essential to overcoming the crisis. But it is also
because the IMF's view has shifted.
"Over its history, the IMF
has become less dogmatic about fiscal austerity being always the right
response to a crisis," said Laurence Ball, economics professor at Johns
Hopkins University, and a part-time consultant to the IMF.
days, the fund worries more than it did about the negative impact that
cutting budgets has on short-term growth prospects—a traditional concern
of Keynesian economists.
"Fiscal consolidation typically has a
contractionary effect on output. A fiscal consolidation equal to 1% of
[gross domestic product] typically reduces GDP by about 0.5% within two
years and raises the unemployment rate by about 0.3 percentage point,"
the IMF said in its 2010 World Economic Outlook:
But that isn't
the full story. In the first place, the IMF agrees that reducing
government debt—which is what austerity should eventually achieve—has
long-term economic benefits. For example, in a growing economy close
with strong employment, reduced competition for savings should lower the
cost of capital for private entrepreneurs.
That suggests that,
where bond markets give governments the choice, there is a legitimate
debate to be had about timing of austerity. The IMF economic models
suggest it will be five years before the "break-even" point when the
benefits to growth of cutting debt start to exceed the "Keynesian"
effects of austerity.
There is an alternative hypothesis that has
a lot of support in Germany, and among the region's central bankers.
This is the notion that budget cutbacks stimulate growth in the short
term, often referred to as the "expansionary fiscal contraction"
Manfred Neumann, professor emeritus of economics at
the Institute for Economic Policy at the University of Bonn, said the
view is also called the "German hypothesis" since it emerged from a
round of German budget cutting in the early 1980s.
effect of austerity is much stronger than most people believe," he
said. The explanation for the beneficial impact is that cutting
government debt generates an improvement in confidence among households
and entrepreneurs, he said.
The IMF concedes there may be
something in this for countries where people are worried about the risk
that the government might default—but only up to a point. It concedes
that fiscal retrenchment in such countries "tends to be less
contractionary" than in countries not facing market pressures—but
doesn't conclude that budget cutting in such circumstances is actually
Each side of the debate invokes its own favored
study. Support for the "German hypothesis" comes from two Harvard
economists with un-German names—Alberto Alesina and Silvia Ardagna. But
their critics, who include Mr. Ball, say their sample includes many
irrelevant episodes for which their model fails to correct—including,
for example, the U.S. "fiscal correction" that was born out of the U.S.
economic boom of the late 1990s.
Mr. Alesina didn't respond to an
email asking for comment, but Mr. Neumann said he isn't confident that
studies, such as the IMF's, that appear to refute the hypothesis manage
to isolate the effects of the austerity policy from other effects of a
Some of the IMF's conclusions, however, bode ill for the euro zone's budget cutters.
first is that the contractionary effects of fiscal retrenchment are
often partly offset by an increase in exports—but less so in countries
where the exchange rate is fixed. Second, the pain is greater if central
banks can't offset the fiscal austerity through a stimulus in monetary
policy. With interest rates close to zero in the euro zone, such a
stimulus is hard to achieve. Third, when many countries are cutting
budgets at the same time, the effect on economic activity in each is
If you are a government in budget-cutting mode, there
are, however, better and worse ways of doing it. The IMF says spending
cuts tend to have less negative impact on the economy than tax
increases. However, that is partly because central banks tend to cut
interest rates more aggressively when they see spending cuts.
Neumann sees an austerity hierarchy. It is better to cut government
consumption and transfers, including staff costs, than government
investment—though it may be harder politically. If you are raising
taxes, better to raise those with no impact on incentives—such as
inheritance or wealth taxes—than those that hurt incentives, such as
income or payroll taxes.
Raising sales or value-added taxes may
have less impact on incentives—but have other undesirable effects, such
as increasing inflation, that could deter central banks from easing