History suggests that austerity and growth just do not mix
TO LISTEN to Barack Obama, there is no trade-off between supporting a weak economy and tackling America’s strained public finances. “We have to cut the spending we can’t afford so we can put the economy on sounder footing,” the president said on July 2nd. Big spending cuts are necessary, he added, to “give our businesses the confidence they need to grow and create jobs”. Perhaps. A successful outcome to talks between Congress and the White House over a multi-trillion-dollar package of budget cuts is clearly preferable to a chaotic debt default. Then again, public-sector job losses helped drive the unemployment rate up to 9.2% in June, which didn’t obviously do a lot for confidence.
Mr Obama is not alone in arguing that austerity can boost growth: Britain’s deficit-slashing coalition government and the European Central Bank (ECB) also make the case. A decline in interest rates due to a lower probability of default should support investment and asset prices. Expectations of lower future taxes and higher lifetime earnings may encourage investment and spending. A new ECB working paper argues that “a fiscal contraction may turn out to be expansionary if the expectation channel becomes sufficiently strong.” In practice, however, it rarely works out that way. In a recent study of 173 fiscal-policy changes in rich countries from 1978 to 2009, economists from the IMF found that cutting a country’s budget deficit by 1% of GDP typically reduces real output by about two-thirds of a percentage point and raises the unemployment rate by one-third of a percentage point.
Occasionally, an economy will buck the trend. In a new paper, Roberto Perotti of Bocconi University presents a series of case studies of “expansionary austerity”, in which cuts in spending coincide with GDP growth. Support for the confidence theory is scarce. In only one of the cases considered—a period of Danish fiscal consolidation from 1983 to 1986—did rising domestic demand lead an expansion. And Denmark in 1983 could scarcely be more different from America today. Its economy was stronger, growing at 4% per year when austerity began (compared with 1.9% in the first quarter for America). More important, Denmark had stratospheric interest rates. Consolidation succeeded in bringing long-term rates down from a peak of 23%. Durable-goods consumption and investment boomed. House prices rose by 60% from 1982 to 1986, raising household wealth and buoying confidence. In America the long-term interest rate is already on the floor, at under 4%, yet consumption remains anaemic. Housing markets are stuck in a post-crash funk. With interest rates low, an austerity-induced fall in inflation would increase real rates and weaken an already listless economy.
Rising domestic confidence is not the only route to growth amid austerity. Foreign demand is typically more important. From 1987 to 1989 Ireland’s fiscal balances improved and debt declined even as growth accelerated. Once again, falling interest rates mattered: long-term rates stood at around 13% when cuts kicked in. But exchange rates mattered more. In the year immediately before Ireland tightened its belt, its currency appreciated by 20% against that of Britain, its largest trading partner. The trend reversed in early 1987 and sterling subsequently rose by 17% against the punt. Irish exports surged by 10% a year from 1987 to 1990, accounting for most of the economy’s impressive growth.
Italy’s 1990s austerity programme, often cited by European policymakers as proof that a country like Greece can wrestle down its huge debt burden, tells a similar story. From 1991 to 1998 Italy moved its budget to surplus and stabilised its debt, only briefly dipping into recession in 1993. Here, too, a plunging currency proved essential. In September 1992 Italy was forced out of the European Exchange Rate Mechanism, a pre-euro system of semi-pegged currencies. Over the next few years the lira fell by roughly 40% against the D-mark. Italy’s current-account balance swung to surplus and growth leapt. There is a lesson in this for Greece, but not the one euro-zone leaders wish to impart.
America will struggle to duplicate these successes. The scope for increasing exports is limited by the process of debt reduction in other rich economies. Exports account for a relatively small share of activity in America’s economy in any case, leaving less room for a trade-led boom. Its second-largest trading partner, China, manages its currency against the dollar and would resist a dollar depreciation. Whenever investors seek shelter, even from an American slowdown, they choose Treasuries, and thus the dollar. In an economy constrained by low interest rates, a stubborn trade deficit and natural demand for the world’s reserve currency, there is little to cushion the blow of austerity.
Spending down, Fed up
A last lifeline for the president is the hope of support from the Federal Reserve. Central banks can partially offset the negative effect of budget cuts with looser monetary policy. The IMF economists find that spending cuts are more expansionary than tax increases precisely because central banks are more willing to compensate for the former. A Fed that is less concerned about public debt may more be prepared to act. But with interest rates near zero, the Fed’s choices are limited to unconventional policy options, where the threshold for action seems to be higher. External factors, like high commodity prices, may also tie the Fed’s hands. The ECB is already tightening policy because of the effect of high commodity prices on euro-zone inflation.
America cannot wait for ever to rein in its debt. It needs to lay out credible plans for medium-term deficit reduction. But it has more leeway to delay cuts than most other countries, thanks to continued demand for its debt. Another year of recovery would help confidence more than a premature swing of the fiscal axe.
