Fiscal fictions: the growth myth

4 Mar 13
Campbell Leith

A number of governments have been putting their faith in 'expansionary fiscal consolidation' to grow their way out of recession. If this sounds like a contradiction in terms, it's probably because it is 

The 2007-09 financial crisis left advanced economies with average levels of debt that, for the first time since the aftermath of the second world war, breached 100 percent GDP levels. In response, most governments have sought to place their fiscal policies on a sustainable path by adopting fiscal consolidation programmes.

Textbook analyses of government spending cuts and tax increases suggest that such efforts to reduce government debt will inevitably depress the economy. But there is an, admittedly controversial, view that raises the tantalising prospect of an expansionary fiscal consolidation, whereby the 
economy actually expands following such policies.

Such episodes were initially discussed in the context of debt stabilisation efforts in the 1980s in Denmark and Ireland. But there have since been claims that they can be found in many other countries, in other time periods. This possibility of an expansionary consolidation has been seized upon by some politicians; for 
example, the British chancellor George Osborne, who argued in his emergency Budget of May 2010 that it would 'stimulate economic growth and confidence'.

The argument in support of such an apparently paradoxical result is based on the idea that undertaking a fiscal consolidation leads to households and firms feeling better about their future economic prospects. This then spurs current investment and consumption decisions which more than offset the negative consequences of the fiscal tightening.

In recentthat I have conducted with Eric Leeper and Huixin Bi, we have taken this thesis at face value and attempted to assess whether or not such effects could plausibly generate an expansionary fiscal consolidation in typical developed economies, particularly those in the eurozone.

Our analysis shows that a very particular set of conditions must be in place to generate an expansionary fiscal consolidation. If any one of these conditions is not fulfilled, then a consolidation will not expand the economy in the short run.

The first condition is that as debt levels rise, people must come to expect that a fiscal consolidation is imminent. The second requires that consumers and firms anticipate that the fiscal consolidation will be based on higher taxes rather than lower government spending, but the adopted policy surprises people and turns out to rely more on spending cuts than tax increases.

Finally, the third condition requires that the central bank supports the fiscal consolidation by relaxing monetary policy.

While the first condition seems reasonable – we all realise that we live in an age of austerity -  the remaining conditions are not. Historically, fiscal consolidations were often based on tax increases. The data shows that they were likely to contain episodes where governments unexpectedly cut spending rather than raised taxes.

In contrast, an International Monetary Fund report on current fiscal consolidation efforts in eight economies (including those of Ireland, Greece, Portugal and Spain) shows that these are all predominantly based on spending cuts rather than tax increases, which is also the case in the UK.

The IMF and other organisations have also been advising countries to base their debt reduction strategies on spending cuts before tax increases -  advice that politicians who are increasingly reluctant to raise taxes have not resisted.

Given the political environment, it seems unlikely that people will erroneously expect policy makers to return to debt reduction strategies based more on tax increases than spending cuts. And even if consumers and firms did systematically misjudge the likely form the consolidation would take, the third condition is also unlikely to be met.

Economies in the eurozone no longer have control over their national monetary policy. Even those economies, such as the UK, that retain control over interest rates, are currently stuck (internal Bank of England debates notwithstanding) at the zero lower bound.

Central banks generally cannot simply cut interest rates in support of fiscal consolidation efforts. And even if they could, countries like the UK are seeing inflation staying stubbornly above the official inflation target (partly in response to the inflationary consequences of changes in tax policy), making it unlikely that central banks will ease further.

So, conditions are not ripe for a fiscal consolidation to expand economic activity in any of the developed economies. But there is also an additional message about policy.
Even if it were possible to engineer the conditions that would deliver an expansionary fiscal consolidation, this is unlikely to be a good thing.

An expansionary fiscal consolidation relies on depressing the economy by leading households and firms to believe that 
one debt reduction strategy will be followed, only to induce a boom by implementing a different, less costly, policy. It works by fooling people, which is rarely desirable. In short, debt reduction is, inevitably, a long and painful process.

Campbell Leith is professor of macroeconomics at the University of Glasgow. Along with Huixin Bi and Eric Leeper, he is an author of  Uncertain fiscal consolidations, published in the , February 2013

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