Austerity

FISCAL CONSOLIDATION: CROSS-COUNTRY EVIDENCE FROM THE PAST THREE DECADES

Cuts in public spending are more effective than tax hikes for putting government finances back in shape. But both can lead to worsening government finances if they go on too long. These are among the many findings of research on government austerity measures in several industrialised countries over the last 30 years.

The study by Luca Agnello, Vítor Castro and Ricardo Sousa, presented at the Royal Economic Society’s 2013 annual conference, looks at the determinants of the duration of fiscal consolidation programmes in 17 industrialised countries over the period 1978-2009. It finds that:

• Cuts in government spending are more effective than tax hikes at delivering fiscal consolidation.
• Fiscal authorities need to pay a special attention to the evolution of public debt when implementing austerity measures.
• A sound macroeconomic environment is a pre-condition for the success of fiscal consolidation.
• Countries that are more open to trade may be better able to bring their public finances on to a sustainable path.
• A supra-national institutional framework may play an important role in imposing discipline on governments to shorten the length of fiscal consolidations.

The study also concludes that the likelihood of a fiscal consolidation programme ending increases over time but only until about the ninth year of duration, after which the likelihood of ending decreases. The authors argue that this suggests austerity has to be quick to avoid ‘adjustment fatigue’.

The findings of this study are relevant to many industrialised countries today where the debate over when austerity should end is becoming increasingly heated. The authors comment.

‘Understanding the timing and the length of fiscal consolidation programmes and, in particular, their determinants, is crucial.

‘Weighing up the trade-off between consolidation of public finances and economic growth is of vital importance for the formulation of effective policies.’

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This study assesses the fiscal and macroeconomic determinants of the duration of fiscal consolidations for 17 industrial countries over the period 1978-2009. It shows that fiscal variables (such as the budget deficit and the level of public debt) and economic factors (such as GDP per capita, the interest rate, the degree of openness and the interest rate) are key in the fiscal consolidation process.

The Great Recession had a major impact on the public finances of many developed countries around the world. While the fiscal stance was sound in 2007, the recessionary effect associated with the most recent financial turmoil, the funds transferred by fiscal authorities with the ultimate goal of rescuing the banking sector and the discretionary measures adopted by several governments in an attempt to boost economic activity have led to substantial fiscal deficits and pushed public debt to historically high levels.

The shift from stimulus to austerity came in 2010 and was the natural consequence of the view about the need to withdraw such expansionary fiscal policies as the economic recovery materialised. In addition, after the explosion of the Greek crisis, urgent measures were requested from several countries to avoid being the next in line and to convince markets that they were different. Not surprisingly, fiscal consolidation programmes were quickly designed and austerity packages started to be implemented.

While European countries have emphasised the importance of fiscal consolidation as a pre-requisite for sustainable growth, other countries such as the US and the UK have recognised that fiscal austerity may hurt short-term growth and are allowing a longer adjustment over time.

In this environment, understanding the timing and length of fiscal consolidation programmes and, in particular, their determinants, becomes crucial. In fact, weighing up the trade-off between consolidation of public finances and economic growth is of vital importance for the formulation of effective policies. This study analyses such issues.

The results show that the state of the fiscal stance and the soundness of the macroeconomic environment play a determinant role in explaining the duration of fiscal consolidation programmes. In particular, the researchers find that:

• higher budget deficits require a longer consolidation process;
• increasing public debt levels undermine fiscal consolidations;
• spending-driven consolidations are shorter than tax-driven consolidations;
• both types of consolidations are shorter in European countries;
• sound economic conditions contribute to shorter consolidations;
• lower interest rates and higher trade openness promote a faster consolidation;
• and the size of the consolidation programme does not seem to affect its duration.

The study also concludes that the likelihood of fiscal consolidation programmes ending increases over time but only until about the eighth/ninth year of duration; then, it starts to fall. This is in line with the idea of an ‘adjustment fatigue’ that can compromise the successfulness of fiscal consolidation.

From a policy perspective, the research:

• corroborates the argument that cuts in government spending are more effective than tax hikes at delivering fiscal consolidation;
• emphasises that fiscal authorities need to pay a special attention to the evolution of public debt when implementing austerity measures;
• indicates that a sound macroeconomic environment is a pre-condition for the success of fiscal consolidation;
• points out that countries that are more open to trade may be better able to bring public finances on to a sustainable path;
• and highlights the important role that a supra-national institutional framework imposing discipline on governments may play as a device to shorten credibly the length of fiscal consolidations.

ENDS


Contact:
Vítor Castro: +351936429570 (vacastro@fe.uc.pt)

RES media consultant Romesh Vaitilingam:
+44 (0) 7768 661095
romesh@vaitilingam.com
@econromesh