The "Austerity myth": Gain Without Pain?

Working Papers No 362
December 2011

Abstract:

As governments around the world contemplate slashing budget deficits, the "expansionary fiscal consolidation hypothesis" is back in vogue. I argue that, as a statement about the short run, it should be taken with caution.

Alesina and Perotti (1995) and Alesina and Ardagna (2010) (AAP) have argued that fiscal consolidations may be expansionary if implemented mainly by cutting government spending. IMF (2010) criticizes the data and methodology used by AAP, and reach opposite conclusions. Some of the methodological critiques are correct. However, the implementation of the IMF methodology has several problems of its own. I then argue that because of the multi-year nature of the large fiscal consolidations, which are precisely the most informative ones, using yearly panels of fiscal policy is limiting. I present four detailed case studies, two - Denmark and Ireland - undertaken under fixed exchange rates (the most relevant case for many Eurozone countries today) and two - Finland and Sweden - after floating the currency.

All four fiscal episodes were associated with an expansion; but only in Denmark the driver of growth was internal demand. However, after three years a long slump set in as the economy lost competitiveness. In all the others for a long time the main driver of growth was exports. In Ireland this occurred because the sterling coincidentally appreciated. In Finland and Sweden the currency experienced an extremely large depreciation after floating.

In all consolidations interest rate fell fast, and wage moderation played a key role in generating a gain competitiveness and a decline in interest rates. Wage moderation was facilitated by the direct intervention of the government in the wage negotiation process. In Finland and Sweden, the adoption of inflation targeting at the same time of the consolidation helped the decline in interest rates.

These results cast doubt on at least some versions of the "expansionary fiscal consolidations" hypothesis, and on its applicability to many countries in the present circumstances. A depreciation is not available to EMU members today (except vis à vis countries outside the Eurozone). A net export boom is not feasible for the world as a whole. A further decline in interest rates is unlikely in the current situation. And incomes policies are not popular nowadays; moreover, international experience, and the Danish case, suggest that they are ineffective after a few years.

JEL Classification: E62, E65, F32

Keywords:  expansionary fiscal consolidations