Economics

The IMF’s 10 lessons for fiscal consolidation

121412fiscal

Ramesh Ponnuru and David Beckworth look at how the Fed could offset the fiscal cliff. On the same topic, the IMF looked at fiscal consolidations and came to these conclusions:

1. The idea that fiscal austerity triggers faster growth in the short term finds little support in the data.

2. Fiscal retrenchment typically has contractionary short-term effects on economic activity, with lower output and higher unemployment. A budget cut equal to 1 percent of GDP typically reduces domestic demand by about 1 percent and raises the unemployment rate by 0.3 percentage point.

3. At the same time, an expansion in net exports usually occurs, and this limits the impact on GDP to a decline of 0.5 percent.

4. Central banks usually offset some of the contractionary pressure by reducing policy rates, and longer-term interest rates typically decline, cushioning the impact on domestic demand.

5. Undertaking fiscal consolidation is likely to have more negative short-term effects if—as is currently the case in a number of countries––interest rates are near zero and central banks are constrained in their ability to provide monetary stimulus.

6. A decline in the real value of the domestic currency typically plays an important cushioning role by spurring net exports and is usually the result of nominal depreciation or currency devaluation. Therefore, because not all countries can have real depreciations and increase their net exports at the same time, simultaneous fiscal consolidation by many countries is likely to be particularly costly.

7. Fiscal retrenchment is also likely to be more costly for members of a monetary union where scope for a fall in the value of their currency is reduced. At the same time, in the current global environment, heightened market sensitivity to fiscal deficits and government debt may imply that no adjustment could have a negative impact on growth.

8. The findings also suggest that spending-based deficit cuts, particularly those that rely on cuts to transfers, have smaller contractionary effects than tax-based adjustments. A key reason for this difference is that central banks typically provide less monetary stimulus during tax-based adjustments, particularly when they involve hikes in indirect taxes that put upward pressure on inflation.

9. Fiscal retrenchment in countries that face a higher perceived sovereign default risk tends to be less contractionary. But expansionary effects of consolidation are unusual even for this group. This result implies that short-term negative effects are likely to be smaller in economies currently facing greater market pressure. I

10. In addition, fiscal consolidation is likely to be beneficial over the long term. In particular, lower debt is likely to reduce real interest rates and the burden of interest payments, allowing for future cuts to distortionary taxes. These effects will likely crowd in investment and increase output in the long term.

Shorter: Tax hikes, tight money, stable currencies, and multiple countries retrenching make for more economically damaging fiscal consolidations.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>