Just a factual update on the austerity debate. Some of the Austerians are getting worried that things might be going too far. The IMF has swung between wanting governments to step up the pace of austerity, or ‘fiscal adjustment’ as the IMF calls it, and taking it more easily. In the IMF’s quarterly Fiscal Monitor released last February, the IMF reckoned that the governments of the mature capitalist economies were reducing their budget deficits by an average of 2% pts of GDP this year, with Eurozone governments cutting 3% pts. The IMF thought this was good news. But now in April it is showing some doubts.
Its own research reveals that cutting government spending and raising taxes can reduce economic growth to the point where government deficits and debt to GDP stop falling because GDP is falling even more. As the US credit agency, S&P put it in its own analysis recently: “a reform process based on a pillar of fiscal austerity alone risks becoming self defeating, as domestic demand falls in line with consumer rising concerns about job security and disposable incomes reducing tax revenues”. This is the issue facing the US economy. Unless, there is a deal between the incoming President and Congress for the 2012-13 budget starting in October, then built-in automatic ‘fiscal adjustments’ (from not renewing tax cuts and not extending unemployment compensation) will reduce the annual deficit by 4% points in one year. That could wipe out the expected 2% real growth in 2013.
In its latest Fiscal Monitor released yesterday, the IMF now thinks that if public sector debt ratios are large and economies are in a recession then ‘fiscal adjustment’ can be counterproductive: “in downturns, fiscal consolidation reinforces the economic cycle and thereby excerbates the slump in growth, making an upfront fiscal contraction particularly harmful” (IMF FM April 2010, p15). So now the IMF advises that “when feasible (!), a more gradual fiscal consolidation is likely to prove preferable to an approach that aims at “getting it over quickly”.
The investment bank JP Morgan has also released new research that shows that the fiscal multiplier (see my previous post, The austerity debate, 14 April 2012) is around 0.7 for the Euro area economies (excluding Greece). That means fiscal tightening of 1% pt a year reduces real economic growth by 0.7% pt a year. If you include Greece, the multiplier is even higher. It means that more fiscal tightening is helping to drive the economic recession in Portugal, Spain, Italy and other Eurozone countries even deeper and that budget deficit targets will not be met as a result. Now the IMF reckons that the fiscal multiplier, at least in the short term could be even larger, namely 1% pt fall in growth for every 1% pt of GDP tighter fiscal policy: “Assuming, in line with recent fiscal adjustment packages in advanced economies, that two-thirds of the adjustment comes from spending measures, a weighted average of spending and revenue multipliers in downturns yields an overall fiscal multiplier of about 1.0.”
And economists at Goldman Sachs have now waded into the debate with their estimate of the US fiscal multiplier (see GS Fiscal multipliers at times of economic slack and when monetary policy is at zero bound 041912). They reckon that a 1% of GDP reduction in government spending reduces real GDP by as much as 1.8% during times of economic slack. They conclude that “fiscal tightening is likely to be particularly painful at present” and that “fiscal stimulus could be an effective policy to stimulate the economy”. But then they do the usual backtracking towards the view of the Austerians by adding that “there is the possibility that a large fiscal stimulus could propel the economy out zero bound (ie push interes rates up) and thereby lower the fiscal multiplier”.
So in its latest World Economic Outlook, the IMF backs away from its previous hardline on fiscal adjustment. “Austerity alone cannot treat the economic malaise in the advanced economies,” the IMF said, “sufficient fiscal consolidation is taking place but should be structured to avoid an excessive decline in demand in the near term”. The problem is that if nothing is done about fiscal adjustment, then government deficits and debt will continue to get out of control. If no further action is taken, then the IMF forecasts that the gross government debt to GDP ratio in most advanced capitalist economies will continue to rise over the next five years. It forecasts that the G7 average would reach 130% by 2017, with 113% for the US and 91% for the euro area and 256% for Japan! If further action is taken, as it expects, then the G7 gross debt ratio would still rise but peak at 124% in 2017, compared to 85% in 2007 before the crisis. For the advanced capitalist economies as a whole, it would peak at 109% of GDP in 2017 compared to 60% in 2007. So after seven years of austerity (2010-17), government debt would still 80% higher than before the crisis
That’s why 2017 wont be the end of austerity. The IMF wants to see the average government debt ratio go back to the 60% reached in 2007. So it talks about what it calls ‘second generation’ fiscal measures. To achieve this, the IMF says “the search should be for credible long-term commitments—through a combination of decisions that decrease trend spending and put in place institutions and rules that automatically reduce spending and deficits over time. ” The main aim is to cut health, pensions and other ‘age-related’ spending out of government budgets.
Which countries would have to make the biggest adjustment? A “second generation” of UK austerity measures would outstrip programmes in both Greece and Portugal. Only the US, Japan and Ireland are facing a larger adjustment among advanced economies. To bring public debt down from 82.5%c to 60% of GDP and pay for rising health and pension costs, the UK will need a fiscal adjustment strategy over the next 18 years equivalent to 11.3% of national output, or roughly £170bn! By comparison, the existing UK £123bn austerity programme is equivalent to 7.5% of GDP, although over a shorter period. It’s austerity for a generation.
So the IMF is worried that too much austerity will cut economic growth and deepen the long depression. And yet it wants a programme of austerity out to 2030 that will destroy the role of government in providing social needs and end what is left of the welfare state.