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After a government gets into trouble for racking up unsustainable levels of debt, how fast should it go about restoring its fiscal credibility? Should it seek to lessen its fiscal “pain” by spreading out spending cuts over a long period of time, or should it, in effect, rip the bandages off as quickly as possible, even though that action might mean more pain and even higher debt in the short term?
A new paper published by European Central Bank economists argues that it is generally a good idea for countries that need to enact budget cuts and slash fiscal outlays to get it done quickly, as this can reduce the total fiscal pain and stabilize debt more quickly.
“Simulations using plausible assumptions suggest that frontloading consolidation reduces the total consolidation effort and stabilises the debt ratio more quickly, although it does imply larger short-term reductions in output,” write the authors in a paper.
The paper looks at the impact of fiscal consolidation on a country’s output, or what economists call the “fiscal multiplier.” The authors conclude that “even in the presence of a large fiscal multiplier, fiscal consolidation could initially lead to a higher debt ratio, but this effect will typically be reversed within a few years.”
Examples of countries that followed this strategy include: Estonia, Iceland, Ireland, Latvia, Lithuania and Slovakia, each of which enacted austerity programs that greatly emphasized cutting spending over increasing taxes. Each of these nations experienced short-term pain from their spending cuts, but each has since experienced robust economic growth.
AEI’s Jim Pethokoukis summarizes the lessons learned:
In other words, although austerity can have longer-term gains, don’t expect to avoid short-term pain through some sort of “cut to grow” or “expansionary austerity” mechanism. This very much syncs with recent research from economist Alberto Alesina, perhaps the most noted proponent of the idea that fiscal retrenchment can boost growth. In the paper “Austerity in 2009-2013?,” Alesina finds that austerity measures “based upon cuts in spending are much less costly, in terms of output losses, than those based upon tax increases.”
So if you are looking to cut debt, spending cuts hurt economic growth less than tax hikes. While both pull demand from the economy, one is less distorting of incentives to work, save, and invest. But there is some pain either way, one reason that fiscal austerity should be accompanied by offsetting monetary policy, as seems to have happened in the US in 2013.
In that last sentence, Pethokoukis is referring to the Federal Reserve’s implementation of its third series of Quantitative Easing (QE) measures, which successfully offset the small negative impact of U.S. federal government spending cuts and the much more negative impact of tax hikes that took effect in January 2013. Without QE, the U.S. economy would have experienced the same kind of recessions as did Spain, Greece and France in the years from 2010 through the present.
Which is to say that when a government’s fiscal solvency is at stake, the fastest path to curing the condition is to rip the bandages off as quickly as possible, the pain from which can be minimized by administering “anaesthesia” through monetary policy at the same time.