Successful Austerity in the United States, Europe and Japan

According to a new IMF working paper:

The large fiscal legacies of the global financial crisis have reignited the debate around the impact of fiscal policy onto economic activity during fiscal consolidations. The analysis in this paper shows that withdrawing fiscal stimuli too quickly in economies where output is already contracting can prolong their recessions without generating the expected fiscal saving. This is particularly true if the consolidation is centred around cuts to public expenditure—likely reflecting the fact that reductions in public spending have powerful effects on the consumption of financially-constrained agents in the economy—and if the size of the consolidation is large. Large consolidations make recessions more likely even when made at an expansion time. From a policy perspective this is especially relevant for periods of positive, though low growth. Accordingly, frontloading consolidations during a recession seems to aggravate the costs of fiscal adjustment in terms of output loss, while it seems to greatly delay the reduction in the debt-to-GDP ratio—which, in turn, can exacerbate market sentiment in a sovereign at times of low confidence, defying fiscal austerity efforts altogether. Again this is even truer in the case of consolidations based prominently on cuts to public spending. 

Thus, a gradual fiscal adjustment, with a balanced composition of cuts to expenditure and tax increases boosts the chances that the consolidation will successfully (and rapidly) translate into lower debt-to-GDP ratios. Monetary policy can likely help alleviate further the pain of fiscal withdrawal if it is used proactively via reduction in the real interest rate.

Posted by at 7:45 PM

Labels: Unemployment


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