On successful fiscal consolidations

In a recent Vox piece, Alesina and Giavazzi argue that “adjustments achieved through spending cuts are less recessionary than those achieved through tax increases”. At first sight this seems to contradict basic macroeconomics. As I and others have pointed out on many occasions, the impact of cuts in government spending on goods and services are passed straight through to demand, while the income effect of temporary increases in tax will be smoothed by consumers. That is why balanced budget but temporary cuts in government spending are deflationary.

However, what we may have here is just another example of failing to condition on monetary policy. One of the most comprehensive studies of this issue, discussed by Alesina and Giavazzi, is contained in an IMF report, which uses a ‘narrative’ approach to identifying episodes of fiscal consolidation. (This approach was applied to monetary policy by Romer and Romer here: the detailed catalogue of fiscal events is in this IMF working paper. See Jeremie Cohen-Setton (Bruegel) for more on this.) As Alesina and Giavazzi are a little unfair in the way they characterise this report, I will quote extracts from its first four conclusions.

1)    “Fiscal consolidation typically has a contractionary effect on output. A fiscal consolidation equal to 1 percent of GDP typically reduces GDP by about 0.5 percent within two years and raises the unemployment rate by about 0.3 percentage point.”

2)    “Reductions in interest rates usually support output during episodes of fiscal consolidation”

3)    “A decline in the real value of the domestic currency typically plays an important cushioning role by spurring net exports and is usually due to nominal depreciation or currency devaluation.”

4)    “Fiscal contraction that relies on spending cuts tends to have smaller contractionary effects than tax-based adjustments. This is partly because central banks usually provide substantially more stimulus following a spending-based contraction than following a tax-based contraction. Monetary stimulus is particularly weak following indirect tax hikes (such as the value-added tax, VAT) that raise prices.”

The reaction of monetary policy is crucial here. As the report makes clear, if interest rates cannot fall to offset the impact of fiscal consolidation, or if currencies cannot depreciate because everyone is implementing austerity, the deflationary impact will be much greater.

            To quote Alesina and Giavazzi, the report’s authors “agree that spending-based adjustments are indeed those that work – but not because of their composition, rather because almost ‘by chance’ spending-based adjustments are accompanied by reductions in long-term interest rates, or a stabilisation of the exchange rate, the stock market, or all of the above.” That is unfair. As the quotes above show, and any reasonable reading of the whole report confirms, the impact of consolidation is directly linked to the way monetary policy works. Perhaps the crime committed by the IMF report is that it didn’t stress enough the effects of taxes on the confidence of entrepreneurs that Alesina and Giavazzi seem to think is central.

            Point (4) does indeed imply that cutting spending is less contractionary than raising taxes, but again the reaction of monetary policy is crucial. If, as is suggested, monetary policy does not reduce interest rates following tax increases because of the impact of taxes on prices, then it is monetary policy that is leading to the difference in the impact of spending and taxes.

            There is another interesting, if tentative, result from this analysis. Government spending here includes transfers as well as consumption and investment. The report finds that cutting transfers is mildly expansionary, while the costs of cutting consumption or investment are greater, although they do caution about small sample sizes. As cuts in transfers can be smoothed, this fits with basic theory. Alternatively, it may be that cutting transfers is signalling some kind of intent, which may in turn encourage the monetary authority to ease monetary policy more.

            The reason for stressing the role of monetary policy in all these findings should be obvious. At the zero lower bound, monetary policy cannot compensate in the normal way for the deflationary impact of fiscal consolidation. We cannot use evidence from the past when monetary policy was not so constrained to tell us what will happen today. This is well known for austerity in general, but it applies equally to the composition of fiscal consolidation.