Perverse Fiscal Consolidation

Between 2011-2013 IMF documents and research papers have revised upwards earlier estimates of fiscal multipliers, which throughout 1970-2009 were assumed by the IMF and other international organisations to be on average about 0.5 for advanced countries (Blanchard and Leigh 2012, 2013, Batini et al. 2012, Cottarelli and Jaramillo 2012 and other researchers associated with the IMF).

The upward revision applies from 2010 and was justified by: the ineffectiveness of countervailing monetary expansion close to the zero floor of the interest rate, lack of opportunities for exchange rate devaluation especially in the Euroarea, by a large gap between potential and actual income (for fiscal multipliers are higher in a downturn than in a boom); and by simultaneous recent consolidation across countries.  Moreover, the fiscal multiplier for expenditure cuts – contrary to earlier claims - turns out to be much (up to ten times) higher than for tax rises.

This means that fiscal consolidation is more expensive in terms of output loss than previously believed.  But there is worse: the higher are fiscal multipliers, the higher is the probability that fiscal consolidation will have the perverse effect of actually raising the Public Debt/GDP ratio. 

Namely:  a fiscal consolidation (tax increases plus government expenditure cuts) will always necessarily result in an increase instead of a decrease of the Public Debt/GDP ratio, with respect to what that ratio would have been in the absence of fiscal consolidation, as long as the fiscal multiplier – or more precisely the weighted average of fiscal multipliers applicable to the composition of the fiscal package – is greater than the inverse of the country’s Public Debt/GDP ratio. Thus in such circumstances fiscal consolidation, contrary to received wisdom, will make Public Debt more rather than less costly to re-finance, and therefore less instead of more sustainable. In plain words, fiscal consolidation works only in those countries that, having a sufficiently low Public Debt/ratio, do not actually need a consolidation.

Here is the proof. Given D=Public Debt, Y=GDP, d=D/Y, x=the size of fiscal consolidation (tax rises plus expenditure cuts of given composition) expressed as a share of GDP, 

ΔD=-xY

ΔY= -mxY

where m is the appropriate fiscal multiplier,

Δ(D/Y) = [(ΔD)Y – (ΔY)D]/Y² = 

= [(-xY)Y – (-mxY)D]/Y²

= -x Y²/Y² + mxY D/Y² =

= -x + mxD/Y = mxd – x  and therefore                 

Δ(D/Y) = x(md – 1) = xd(m – 1/d)

from which we can see that the ratio D/Y must increase,
i.e. Δ(D/Y) >0,  if and only if m>1/d.  Q.E.D.

The interest of this proposition is in the fact that the inverse of the D/Y ratio is naturally all the smaller the more heavily indebted a country is, and particularly small with respect to the kind of fiscal multipliers estimates that have been produced in recent literature (such as Blanchard and Leigh 2012, 2013, Batini et al. 2012, Cottarelli and Jaramillo 2012 and other researchers associated with the IMF). Thus the counterproductive nature of fiscal consolidation in advanced economies, especially in highly indebted countries with high fiscal multipliers, is an absolute certainty.   

Figure 1. Illustration of perverse fiscal consolidation raising the Public Debt/GDP ratio (CLICK TO ENLARGE): Δ(D/Y) >0 for plausible values of m and as an increasing function of D/Y. 

The figure above (for which I am indebted to my colleague Marilena Giannetti) illustrates the impact of a fiscal stabilisation package of 5% of GDP, relatively modest by the standards of the current crisis, on the Public Debt/GDP ratio, Δ(D/Y)= x(md – 1), as a function of the current d=D/Y ranging from 50% to over 200% of GDP and for alternative values of fiscal multipliers ranging from 0.5 to 3.5.  At high D/Y ratios and relatively high multipliers still within the range estimated by recent IMF sources, the rise in D/Y can be devastating. 

By way of example, a country with d=1.20, m=3, undertaking a stabilisation of x=5%, would raise its d by 0.05*(1.20*3-1)=13% of GDP, from 1.20 to 1.33.  In a country like Japan, for a Public Debt at over 200% of GDP, a fiscal consolidation package of 5% would lead to an increase of the Public Debt/GDP ratio of the order of 30% of GDP. For a perverse effect of fiscal consolidation on such a massive scale the claim that “The short-term effects of fiscal policy on economic activity are only one of the many factors that need to be considered in determining the appropriate pace of fiscal consolidation for any single economy” (Blanchard and Leigh, 2013, p.6) is facile and disingenuous. Such a regime switch cannot be ignored.

Table 1. Threshold of the fiscal multiplier over which fiscal consolidation necessarily leads to higher Public Debt/GDP ratio for selected countries (calculated as the GDP/Public Debt ratio, from the data estimated by US-CIA, The World Factbook, 2013, for 2012), ranked by increasing value of the multiplier threshold.

Country    Public Debt/GDP      GDP/Public Debt

Japan            214.3                        0.47
Greece          161.3                        0.62
Ireland          118.0                        0.84
Italy              126.1                        0.79
France             89.9                        1.11
UK                  88.7                        1.13
Spain              85.3                        1.17
Germany         81.7                        1.22
Hungary          78.6                        1.27
Austria            74.6                        1.34
US                  73.6                        1.36
Netherland       68.7                       1.45
World  average 64.0                       1.56
Albania            60.6                       1.65
Poland             53.8                       1.85
Finland            53.5                       1.87
Slovakia          48.6                       2.06
Czechoslovakia 43.9                       2.21
Denmark         45.3                        2.21
Sweden           38.6                        2.56
Romania          37.2                        2.69

We have seen above that before the crisis the value of fiscal multipliers generally assumed by the IMF for advanced economies for forty years (1970-2009) was on average 0.5.

This leads to the presumption that – if national fiscal multipliers were all identical to the group average of 0.5 – only in Japan (with a GDP/Public Debt ratio as low as 0.47 in 2012 and 0.43 in 2013) would fiscal consolidation have raised the Public Debt/GDP ratio, and only very marginally at that. In all other countries fiscal consolidation would have worked, lowering both D and the D/Y ratio. 

The lower bound of the fiscal multipliers revised by Blanchard and Leigh (2012 and 2013), at 0.9, would imply a perverse consolidation pattern in 2012 not only in Japan but also in Greece, Ireland and Italy; while the upper bound of 1.7 would add to the list of perverse consolidation also France, the UK, Spain, Germany, Hungary, Austria, the US, the Netherlands and Albania.

The lower bound of the expenditure multipliers estimated by Batini et al. (2012), 1.6, would remove only Albania from the list of perverse fiscal consolidation, but its higher bound 2.6 would include – in addition to the previous list, also Poland, Finland, Slovakia, the Czech Republic, Denmark and Sweden, leaving out Romania as the only country in table 1 in which consolidation would not raise the Public Debt/GDP ratio and reduce GDP growth.  Using the range of estimated multipliers for tax rises, 0.16-0.35, on the contrary, that kind of fiscal consolidation would always work, i.e. would reduce both the absolute level of Public Debt and its ratio to GDP.

For the multiplier estimated by Auerbach-Gorodnichenko (2012b), near zero in normal times to about 2.5 during recessions, fiscal consolidation would work always in a boom, and never in a recession except in Sweden and Romania.  Finally, for Christiano et al. (2011), with the multiplier at 3.2 once the interest rate approaches the zero interest lower bound, all the countries in Table 1 would experience perverse fiscal consolidation. 

It is reasonable to presume that all the IMF researchers involved in this kind of work must have been aware of such devastating implications of the upward revision of fiscal multipliers.  My colleague and good friend Giancarlo Gandolfo helped me to work out the proof of the proposition above linking the multiplier to the inverse of the Public Debt/GDP ratio, for which I am most grateful, but in all honesty he would be the first to point out that the proof does not involve the use of rocket science.  Cottarelli and Jaramillo (2012) who discuss the feedback loops between fiscal policy and growth, get remarkably close to that proposition, but use an obscure turn of phrase, and stop short of stating it in so many words, or mathematically:

“a deceleration of growth prompted by a fiscal consolidation could result in a rise in the government debt-to-GDP ratio. This is found to be the case if the initial stock of debt is large and the fiscal multiplier is high. The effect of fiscal tightening on debt (the numerator of the ratio) in percentage terms is smaller the higher the initial stock of debt to GDP. Meanwhile, the negative effect of fiscal tightening on GDP (the denominator of the ratio) is larger the higher the fiscal multiplier.”

The point is that although the participants in the debate "should not be reported as representing the views of the IMF", as stated in all IMF publications, naturally their writings are taken as a pointer to the way IMF views are evolving.  Therefore they must be anxious not to suggest that their upwards revision might result in perverse fiscal consolidations in all or near all advanced economies, and baulk at saying in so many words that fiscal consolidation backfires precisely in those highly indebted countries on which it is pressed most energetically. Thus Blanchard and Leigh (2013) are adamant:

“... our results should not be construed as arguing for any specific fiscal policy stance in any specific country. In particular, the results do not imply that fiscal consolidation is undesirable.”

And Cottarelli and Jaramillo (2012) make a case against abrupt, front-loaded and simultaneous fiscal consolidations (like Blanchard and Cottarelli had done separately in 2011 and 2012 respectively).  “It is imperative to lower Public Debt over time”, though:  “However, in the short-run, front-loaded fiscal adjustment is likely to hurt growth prospects, which would delay improvements in fiscal indicators, including deficits, debt, and financing costs. A measured, although not trivial, pace of adjustment, based on a clear medium-term plan, is therefore preferable, if market conditions allow it.” Nevertheless, they claim that fiscal consolidation and economic growth go “hand in hand”.

All researchers advocate structural reforms, precisely to offset the recognition that fiscal adjustment will slow down growth.  “Reforms in goods, services, and labor markets that improve economic efficiency will boost potential growth, in turn serving as important tools in the fiscal adjustment process” (Cottarelli and Jaramillo 2012). These cover a multitude of sins and virtues that have mixed and ambiguous effects, if any, and in any case only in a distant long-run.    The notion of a virtuous circle in which “pro-growth fiscal adjustment measures, other structural reforms, and lower debt boost growth and the latter facilitates fiscal adjustment” (ibidem) is pie in the sky, and a dangerous vision if it is used to justify perverse fiscal consolidation.

The proposition that fiscal consolidation harms development only when it is abrupt, front-loaded and internationally coordinated is a non-sequitur.

At this point two further considerations are in order.  First, we know – not least from Cottarelli and Jaramillo (2012, Appendix on Short-run Determinants of CDS Spreads in Advanced Economies) – that a country’s cost of borrowing tends to rise with the Debt/GDP ratio and with the fall in the growth rate, both phenomena being associated with “perverse” fiscal consolidation i.e. with the near totality of consolidations.  For “a deceleration of growth prompted by a fiscal consolidation could trigger nervousness in financial markets” and “...markets seem to have been focusing recently on short-term growth developments.”  “The possible increase in spreads when fiscal policy is tightened creates a problem for upholding a fiscal adjustment strategy, not only because higher financing costs increase the overall deficit, but also because of political economy reasons. If painful fiscal tightening is accompanied by early evidence of an improvement in credibility, the adjustment is more easily sustained, but if markets do not reward the effort, the resolve of the government to carry on the fiscal adjustment may be undermined.”  Therefore fiscal consolidation can and often does generate a vicious circle that makes Public Debt more and more unsustainable. 

Second, we know that in a prolonged depression productive capacity does not just stand idle but is actually destroyed: factories close down with no more than a fraction of their productive capital being re-deployed elsewhere, if at all, in other productive uses; human capital is also destroyed, as workers made redundant are dispersed, and their skills are lost or forgotten or made obsolete.  When actual output falls below potential output, at some point gross investment stops and net investment falls below zero as unused or obsolete capital is not replaced, thus reducing not only employment but the number of those “employable”, pulling down the growth path of potential output (Vianello 2005). “An insufficient demand protracted over time unavoidably generates a slowdown in the formation of new productive capacity and therefore of potential income” (ibidem). Discouraged workers will stop looking for work and the rate of participation will fall.  As Nicholas Kaldor (1983) had argued, “It is illegitimate to assume that there exists a long run equilibrium growth path, for a single country or even the world as a whole, determined by population growth, capital accumulation and the rate of technical progress, all taken exogenously [italics added].” (p. 95).

In such conditions, in the world as we know it, fiscal consolidation definitely can harm economic growth and development, even if it is not abrupt, front-loaded and internationally coordinated.  This is not to say that there are no limits to a country’s or even a group of countries’ ability to sustain a fiscal stimulus.  But fiscal consolidation has to be avoided absolutely as long as the GDP/Debt ratio is smaller than the fiscal multiplier – even if otherwise the country is growing less fast than the interest rate on its debt, for with perverse fiscal consolidation the country would continue to raise its Debt/GDP ratio even faster than with continued fiscal stimulus. 

This is true even if government expenditure consists of Keynes’ proverbial policy of hiring some workers digging holes and others filling them, that Tanzi (2012) would relegate “to the museum of old and wrong ideas” (p. 11).  Obviously the replacement of unproductive expenditure with productive investment has significant additional benefits over a continuation of unproductive investment such as digging and filling holes or building pyramids or cathedrals, but even the continuation of such unproductive investment is superior to fiscal consolidation.  

REFERENCES

Auerbach Alan, and Yuriy Gorodnichenko (2012a), “Fiscal Multipliers in Recession and Expansion,” in Alberto Alesina and Francesco Giavazzi, Fiscal Policy after the Financial Crisis, University of Chicago Press.

Auerbach Alan, and Yuriy Gorodnichenko (2012b), “Measuring the Output Responses to Fiscal Policy,” American Economic Journal – Economic Policy, Vol. 4, pp. 1–27. 

Auerbach Alan, and Yuriy Gorodnichenko (2012c), “Output Spillovers from Fiscal Policy,” NBER Working Paper No. 18578, Cambridge, Mass. 

Batini Nicoletta, Giovanni Callegari and Giovanni Melina (2012), “Successful Austerity in the United States, Europe and Japan”, IMF Working Paper 12/190, July, Washington.

Blanchard Olivier J. (2011), “Blanchard on 2011’s four hard truths”, 23 December,  http://www.voxeu.org/article/blanchard-2011-s-four-hard-truths 

Blanchard Olivier J. and Daniel Leigh (2012), “Box 1.1. Are We Underestimating Short-Term Fiscal Multipliers?” in International Monetary Fund (2012), World Economic Outlook - Coping with High Debt and Sluggish Growth, Chapter, “Global prospects and policies”, pp. 41-43., October, Washington.

Blanchard, Olivier J. and Daniel Leigh (2013), Growth Forecast Errors and Fiscal Multipliers, IMF Working Paper No. 13/1, January, http://www.imf.org/external/pubs/ft/wp/2013/wp1301.pdf 

Christiano Lawrence, Martin Eichenbaum, and Sergio Rebelo (2011), “When Is the Government Spending Multiplier Large?”, Journal of Political Economy, Vol. 119, pp. 78–121. 

Cottarelli Carlo (2012), “Fiscal Adjustment: Too Much of a Good Thing?”, Posted on January 29 by iMFdirect. 

Cottarelli Carlo and Laura Jaramillo (2012), “Walking Hand in Hand: Fiscal Policy and Growth in Advanced Economies”, IMF Working Paper WP12/137 http://www.imf.org/external/pubs/ft/wp/2012/wp12137.pdf

International Monetary Fund, (2010), World Economic Outlook: Recovery, Risk, and Rebalancing, October, Washington 

Kaldor Nicholas (1983), “The role of effective demand in the short run and the long run”, reprinted in Targetti Ferdinando and A. P. Thirlwall, Eds., (1989) Further essays on economic theory and policy – Collected economic essays, vol. 9, Duckworth, London. 

Tanzi Vito (2012), Realistic Recovery - Why Keynesian Solutions Will Not Work, http://www.politeia.co.uk/sites/default/files/files/Vito%20Tanzi%20Final.pdf London, Politeia.

Vianello Fernando (2005), “La Moneta Unica Europea”, mimeo, and in Economia & Lavoro (2013), XLVII-1, pp. 27-46. 

Eurobond, Public Deficit

The following comments on the last three posts were e-mailed by Professor Michael Ellman, Chair of the Department of Business Studies, University of Amsterdam. They deserve wider circulation and are reproduced below with his permission.

Dear Mario,

I read your paper [merging the two recent posts on the Euro crisis] & blog [the post on Schuldenbremse] and am naturally in sympathy with both. I have a few comments:

(1) at the end of your paper you seem to suggest that a default by a EU member state would mean the end of the Euro or even of the EU itself. But why should it? The default of US municipalities or states has never threatened the dollar or the USA. If Greece defaults this will raise interest rates on bonds issued by other 'suspect' EU members and hit badly banks, insurance companies and pension funds that hold Greek debt. This may require the governments of the countries where these institutions are based to recapitalise them, which will worsen their fiscal position. The rise in interest rates for the other 'suspect' countries will worsen their fiscal position and possibly cause more defaults, which might lead to a change in the membership of the EMU. (As for Greece, if it stayed in the EMU it would have to balance its budget immediately since it could neither issue debt on the capital market nor borrow from the central bank, unless - like the UK in World War II - it forced its own banks and other financial institutions to buy national debt which would undermine their solvency and reduce credit to the private sector, as happens under wartime conditions). Of course, if retail depositors were happy to put their money in institutions mainly holding public debt - like the Soviet/Russian Sberbank or the Japanese postbank - then the situation could be stabilised.

(2) motivation for creating the EMU

It is generally considered that the creation of the EMU was a political bargain between Germany and France in which France agreed to German reunification in exchange for Germany giving up its DM. The point of that, from the French perspective, was to end Germany's dominance of European interest-rate policy. However, it now seems that an important result of the EMU will be to impose German ideas about fiscal policy on the EMU - a development which you and I think harmful. It is ironical that an institutional change designed to end German dominance in European monetary policy seems to be heading in the direction of creating a German dominance of fiscal policy.

(3) debt as a "burden"

Naturally John is right that debt interest is a transfer payment. But transfer payments require taxes to pay them. To say that rising debt payments are not a burden is analogous to saying that rising pension payments are not a burden. Rising interest payments on debt are only not a burden if they are of such a magnitude that they do not have negative economic effects (growth of informal sector, emigration, reduction of economic growth). The actual effects are likely to vary from country to country depending on growth rates, employment levels, economic institutions, tax levels, fiscal situation, etc. Try explaining that taxes have no economic effects to Irish ministers under pressure to increase their corporate tax rates.

(4) balanced budgets

There is another aspect to this - the demand for public debt. If states do not continuously issue new debt, where will financial institutions invest the "risk-free" tranche of their investments? To issue too little public debt is to risk a bubble in private sector assets.

(5) EU solidarity

You are quite right to stress that some much discussed possibilities are political non-starters because of a lack of EU solidarity. Here in the Netherlands (which was a gold bloc country in the 1930s) the main aim of economic policy is to bring down the deficit by expenditure cuts (and tax increases) and to bring back the debt level to the 60% level. Support for fiscal transfers to sinners is conspicuous by its absence. Support for EU integration, both among the public and the political elite, has declined markedly in recent years, partly for this reason. Despite everything the Dutch economy is doing reasonably well, with relatively low and declining unemployment. But this is entirely a result of external factors - growth in Germany and elsewhere in the world. Small foreign-trade dependent countries have their level of economic activity largely determined externally. Fiscal orthodoxy enables them to have relatively low interest rates with favourable economic effects.

Best wishes, Michael