Committee for a Responsible Federal Budget

Fiscal Consolidations: How and When

Jun 21, 2010 | Economics

Alberto Alesina of Harvard University has a new paper out that talks about how differences in the composition of debt reduction packages make a difference in terms of success. He looks at which contractions have been fiscally successful, less harmful to growth, fiscally unsuccessful, or more harmful to growth. In addition, he examines the political ramifications of tightening fiscal policy and whether they necessarily lead to the incumbent being voted out of office. The conclusions he draws buck the convential wisdom that all fiscal tightening need be contractionary and that all fiscal tightening need be politically damaging.

How he determines the economic and fiscal success of adjustments goes as follows. For economically successful adjustments, he takes the difference in the average growth rates between that country and the average G7 growth rate over the first three years after tightening. The top 25 percent relative to other episodes of fiscal adjustment are considered "expansionary." Fiscal adjustments are considered successful if they reduce the debt-to-GDP ratio by at least 4.5 percentage points in the first three years.

Alesina then talks about the composition of economic adjustments. He emphasizes their importance in determining the economic and fiscal success of the consolidations. The numbers below show the amount of spending cuts and tax increases in each type of adjustment. As the evidence suggests, spending cuts have produced more growth friendly and more successful fiscal consolidation packages.

[chart:2785]

On the political side, Alesina indicates that there is little relationship between fiscal contraction and political "losses." In fact, he points to past research by Adi Brender and Allan Drazen that suggests "in more experienced democracies voters punish those politicians who opportunistically manipulate fiscal policy to be reelected." 

As for the political conditions that are most conducive to fiscal consolidation:

Stabilizations are more successful and easier to come by in presidential systems, in systems in which the executive faces fewer institutional veto points, in periods of unified government in which the same party holds the executive and the legislature, and in systems in which the majority of the ruling party (or parties) is large.

The last few conditions he mentions are especially intriguing, considering that over the last 30 years in the US, fiscal consolidation has generally taken place in divided governments (George H.W. Bush and the Democrats, Bill Clinton and the Republicans) while much of the fiscal expansion has come when governments were unified.

For the specific economic timing of when to tighten fiscal policy, we turn to Paul Krugman. He has been arguing constantly for new stimulus to prop up the economy in the short run, but in yesterday's New York Times, he wrote an op-ed also calling for addressing our fiscal problems after the recovery. He suggested, similarly to Ezra Klein's "worst-of-both worlds," that politicians were in fact doing the worst possible fiscal policy right now: cutting back now, while doing little about the long term budget outlook. The time for fiscal contraction should come "when, and only when, the Federal Reserve has regained some traction over the economy, so that it can offset the negative effects of tax increases and spending cuts by reducing interest rates." So, he argued for a deal that exchanged a fiscal consolidation package for a hold-off on rate hikes by the Federal Reserve (though keeping them at some point above near-zero.)

While he did talk about the medium term outlook in this op-ed, Edmund Andrews slammed a different Krugman op-ed for being too non-chalant about deficits in the next decade (and joined the Announcement Effect Club in the process.) Andrews stated (based on yet another Krugman op-ed) "he thinks we can wait til 2020 to take active measures against the deficit. He even suggests we don't need to start planning until close to 2020." To him (and us), that spells disaster (though obviously Krugman did not say that in his recent piece.) Then came the sentence we were waiting for from Andrews:

I think the existence of a credible plan with a credible political commitment would be a huge relief to the bond markets, well ahead of us actually doing anything.

Timing and composition are everything. If a fiscal package takes effect too soon, it could damage the economic recovery; coming too late, it would not be enough to head off future problems. Spending cuts will have to compose a majority of any deficit reduction package that addresses our long term debt, so Alesina's findings are a good sign that a well-designed plan might not be so economically disastrous. And a good design is exactly what we'll need.