domenica 13 luglio 2014

The austerity debate: Festina lente!, by Carlo Cottarelli

As with austerity itself, the austerity debate shows no sign of disappearing any time soon. This column argues that the last thing that the world economy needs at this uncertain moment is a knee-jerk reaction from fiscal policy. While the column agrees that governments need to make cuts, it stresses they should not lose sight of the bigger picture.
The austerity debate would not be as heated if commentators focused on the current state of the world economy, rather than on how economies work in normal times. If they did, they would see that a pragmatic approach – proceed with moderate adjustment, at a steady pace, if markets allow you to do so – is the best course of action. You may call it the Goldilocks principle: fiscal policy should be just right. Or, if you want to show off your classical studies, you may call it the festina lente principle, with the backing of two thousand years of history.1
So, what are the relevant facts – the special circumstances that characterise global economic conditions now – and what do they imply for fiscal policy? I will focus on advanced economies, because this is where the debate is most heated.
To start with, advanced economies are recovering from the largest economic shock since the Great Depression. In most of them, output is well below potential. In these circumstances fiscal multipliers are larger than those often found in the literature, which are estimated without considering the cyclical position of the economy: when output is near or above capacity, deficit cuts are likely to result in reduced inflationary or current account pressures rather than lower output, biasing down estimates of multipliers that do not control for cyclical positions (see IMF 2012 for new evidence on this).
Two additional factors suggest that fiscal multipliers are relatively high at present.
  • First, the monetary authorities have little scope to lower money market rates to offset some of the deflationary impact of fiscal tightening. Unconventional policies can be used further but their effect on private sector credit is far from certain. The financial crisis has left big scars and has weakened the propensity to lend of financial intermediaries, including because of insufficient own capital.
  • Second, nominal exchange rate depreciation is not an option for the countries that would mostly benefit from it – ie the Eurozone countries with weak fiscal accounts (as a significant portion of their trade is with partners inside the currency bloc).
It could be argued that an expansionary fiscal contraction is at least a possibility in countries where spreads are high and where fiscal consolidation could trigger a return to confidence. Let me be clear about this. These countries will have to frontload fiscal adjustment, given their difficulty in borrowing at sustainable interest rates. But a confidence-inspired decline in spreads that might accompany fiscal tightening in more normal times could be impeded by the current focus of markets on short-term growth developments. If markets believe that fiscal tightening will lead to a decline in growth, spreads will not decline (a problem that seems particularly severe in case of large fiscal tightening, due to nonlinearities in the relationship between growth and spreads; see Cottarelli 2012). This may be a case of multiple equilibria: if markets anticipate that tightening will not slow growth, spreads could fall and growth could indeed be maintained despite a fiscal tightening, while, if markets anticipate that growth will slow, spreads could rise and growth would suffer. But the recent downgrade of some European countries by Standards & Poor’s, citing the negative impact of fiscal tightening on growth, suggest that market behaviour will likely lead to the realisation of the bad equilibrium.
Altogether, we can conclude that a sizeable fiscal tightening would have contractionary effects on the economy (a problem that is magnified by the fact that most advanced economies are tightening at the same time). Spreading the adjustment over time, allocating part of it to periods when the output gap will be smaller and the credit channel will be stronger, would have advantages.
Does this conclusion hold also for expenditure-based consolidations? Probably yes, as the factors that would support the recovery of private sector demand (a monetary-policy expansion, an exchange-rate depreciation, a decline in spreads) are no less impaired at present for spending cuts as they are for revenue increases (as noted by DeLong 2012 on this site). I would argue that, for most advanced countries, an expenditure-based consolidation is preferable. But this is not because one is much less costly than the other in the near term. It is because potential growth in countries where tax rates are already high, as in most European countries, would suffer in the long run from further increases.
So, if moving too quickly with fiscal adjustment is risky, why move at all? I already answered for countries that are under severe market pressure. Markets are already concerned about fiscal credibility in those countries, and promising that the adjustment will come at a later time would just not be credible. What about other countries? They have more room and could slow the pace of adjustment depending on cyclical developments. But even for those, short of a major deceleration in economic activity, postponing the adjustment altogether would be risky for three reasons.
  • First, public debt has never been so high since WWII. High debt may raise sustainability questions; but, more important, when debt is high even relatively small increases in interest rates can move public finances from a good to a bad equilibrium, derailing public finances. In these conditions, deferring fiscal adjustments involves higher risks.
  • Second, market focus on short-term developments makes it more difficult to trade off long-term fiscal tightening (say, reforms in entitlement spending) for short-term fiscal expansion. Spreads do not seem to reflect differences in long-term trends in entitlement spending (Cottarelli 2012), suggesting that long-term reforms may buy little credit from markets in current circumstances.
  • Third, the Greek debt restructuring has broken a taboo that had persisted throughout the post WWII period, namely that debt restructuring does not happen in advanced economies.
Of course, the relative importance of these factors varies across countries. But the main idea is that postponing fiscal adjustment to better times is now more difficult than in the past: a gradual approach would avoid the risk of having to tighten too rapidly later, should markets start having doubts about your credibility. It is a matter of risk management. Note finally that some of the costs related to fiscal adjustment discussed above – for example a possible rise in spreads as growth decelerates – involve some nonlinearities, ie the costs are more likely to occur for large deficit cuts than for moderate adjustments.
The last thing that the world economy needs in this uncertain environment is a knee-jerk reaction from fiscal policy. Proceeding at a moderate speed – with some consideration for cyclical developments but with a clear sense of direction and with a mix of consolidation measures that takes into account long-term efficiency goals – seems the right thing to do. Festina lente!


Cottarelli, Carlo (2012), “Fiscal adjustment: Too much of a good thing?”,, 8 February.
DeLong, J Bradford (2012), “Spending cuts to improve confidence? No, the arithmetic goes the wrong way”,, Lead comment, Has Austerity Gone Too Far debate, 6 April.
International Monetary Fund (IMF), 2012, Fiscal Monitor, April.

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