How to Build a Fiscal Consolidation Package: Some Lessons from the IMF
“Virtually all advanced economies are likely to conduct fiscal consolidation at some point in the future to put their fiscal positions back on a sustainable footing.” - International Monetary Fund, World Economic Outlook, October 2010, p.21
The United States, like a number of other countries, needs to figure out how to best design a fiscal recovery package that will not derail a lackluster recovery, while at the same time, phases in debt reduction policies soon enough and aggressively enough to reassure credit markets.
Helpfully, the International Monetary Fund’s chapter “Will it Hurt? Macroeconomic Effects of Fiscal Consolidation” in the most recent World Economic Outlook provides some answers.
The benefits of fiscal consolidation. For a start, the Fund confirms the bulk of research that shows that fiscal consolidation in high-debt countries will be beneficial and likely increase output over the long-run. A reduction in government debt will reduce the crowding out of private investment as the economy approaches full employment. In fact, the reduction in government debt will “crowd in” private investment - which ultimately raises underlying growth - by lowering inflation-adjusted interest rates and reducing debt service payments. This lesson is clearly relevant for the United States.
But what about the short-run? Fund economists also take a close look at the mixed evidence on short-run costs to the economy from fiscal consolidation. The IMF identifies two things that are likely to help mitigate contractionary effects in the short run and over time: focusing on policy changes that are conducive to growth, including what many refer to as structural policy changes (we have suggested, for example, fundamental tax reform including broadening the tax base significantly, in our paper on reforming tax expenditures, and shifting from a consumption-focused to an investment-focused budget), and increased coordination with other nations.
For advanced economies as a group, policies that have relied on spending cuts, particularly cuts in transfers, have tended to be less contractionary than tax-based adjustments—in part because central banks often have responded to spending cuts by lowering interest rates. Given how low rates are in the U.S., though, this may be less relevant now than it would be normally. Moreover, it is not clear how relevant these findings are to the US now – most of the other advanced economies have started with far higher spending and taxes as a share of the economy, which can reduce the scope for adjustment on the tax side and increase incentives to have spending-heavy programs. It is also not at all clear what motivated the central banks to act in response to spending shifts. These points are critical for the US – and it is important to get them right.
The IMF also found that the contractionary effects are worse when many nations engage in debt reduction all at once. This is why, while we watch what is going on in Britain with admiration and awe and keep our fingers crossed it will work, we realize it may well make our own job even more difficult. If the shaky global economy is a table with each country serving as a stabilizing leg, the risk is that the U.S. will be left as one of the only support systems for demand as other countries engage in debt reduction more aggressively. This is, in part, because they have to, since they do not have our dollar and safe-haven advantages, which our creditors perceive as lowering our sovereign risk (at least for the time being – history shows that confidence can shift suddenly). Under these circumstances, competitive currency devaluation can get nasty, as countries try to boost their exports as much as possible to help their economies when fiscal adjustment is underway. More global coordination would be wise, and it can take many forms.
The IMF finds that even in the bulk of the cases in which fiscal consolidation had a contractionary effect on the economy in the short-run, the negative effects on aggregate demand were often offset through stronger growth in net exports and the easing of monetary policy by the central bank. In the current environment however, there may be limits to these offsets: many major trade partners have fiscal adjustment under way simultaneously and not everyone can boost exports through a depreciating currency at the same time; and because interest rates are near zero, central banks may not be able to provide monetary stimulus as they did in the past.
Luckily, the Fund suggests policy actions to increase fiscal adjustment credibility, which could help limit negative short-run effects: strengthening fiscal institutions, reforming pension entitlements and reforming public health systems. “To the extent such measures improve household and business confidence and raise expectations about future income, they could help support activity during the process of fiscal adjustment”. No question, this won’t be easy and it will not be painless, but there are steps we can take to make the transition easier.