It is probably one of the most important trips in Greece’s modern history. On Friday, the new Greek prime minister Antonis Samaras will travel to Berlin and ask the German chancellor Angela Merkel for more time. His stricken country, he will insist, needs more years to meet the austerity targets. “All we want is a bit of ‘air to breathe’ to get the economy running and to increase state income”, he said in an interview with Germany’s tabloid “Bild Zeitung”.
A new research paper published by the research department of the International Monetary Fund (IMF) backs his claim. Countries trying to consolidate their public finances in the midst of a recession need patience and a steady hand, the paper entitled “Successful Austerity in the United States, Europe and Japan” concludes.
Given the fact that the IMF is part of the troika that insists on severe austerity programs in return for bailout funds, this is quite a perplexing message.
A research team lead by IMF’s economist Nicoletta Batini analysed the history of austerity programs in industrial countries using state-of-the-art macro methods. They came to the conclusion that overly ambitious austerity programs implemented in economic downturns are self-defeating:
“The analysis in this paper shows that withdrawing fiscal stimuli too quickly in economies where output is already contracting can prolong their recessions without generating the expected fiscal saving.”
Without specifically discussing the Greek case, the paper indirectly suggests the excessive fiscal consolidation the troika forced upon the stricken country probably made things worse. According to figures published by the German Council of Economic Advisors, Greece has cut back its fiscal deficits rather vigorously.
From 2009 to 2012 the fiscal deficit shrunk by 9 percent of GDP and the structurally adjusted fiscal deficit was reduced by more than 14 percent. Simultaneously, however, economic output collapsed by more than 20 percent, and public debt exploded.
Excessive austerity measures in a recession can trigger a vicious circle, the IMF researchers warn in their paper. Declining output, diminishing tax revenue and expenditure cuts can reinforce each other – “a snowball effect”, as the economists call it. They advise governments to allocate consolidation measures evenly over several years.
“Frontloading” of cuts – a policy often demanded by the IMF – turns out to be especially damaging to growth:
“Smooth and gradual consolidations are to be preferred to frontloaded or aggressive consolidations, (…) because sheltering growth is key to the success of fiscal consolidation.”
This lesson seems to be especially important for countries that lost the confidence of the financial markets and have to pay high risk premia on public debt, the authors point out.
Their paper has been published as an IMF Working Paper and does not necessarily reflect the official view of the organisation. However, prior to publication, IMF Working Paper are subject to a stringent quality control process.
The results confirm an old hypothesis that dates back to the heydays of John Maynard Keynes. However, a lot of contemporary macro economists have been severely questioning the Keynesian view on fiscal policy and growth for decades. They suggest that fiscal retrenchment can boost economic prosperity even in the short run because it might foster confidence in the private sector.
In real life, however, this theory apparently does not hold the water.
“While it is plausible to conjecture that confidence effects have been at play in our sample of consolidations, during downturns they do not seem to have ever been strong enough to make the consolidations expansionary at least in the short run”, the researchers stress.
This observation supports the results of a different team of IMF economists who looked at the idea of “expansionary austerity” last year. In a paper entitled “Expansionary Austerity: New International Evidence”, Jaime Guajardo, Daniel Leigh and Andrea Pescatori came to the conclusion that previous academic literature on the subject has methodological weaknesses.
In the new paper Nicoletta Batini and her co-authors Giovanni Callegari and Giovanni Melina stress that the growth impact of austerity programs hinges on the economic climate. This is a distinction that most of the previous literature did not make but it turns out to be crucial. In good times, fiscal retrenchment does not do much damage to growth. If the economy is in a recession, however, things appear to be differently.
The results of the new paper are also stunning with regard to the optimal composition of austerity programs. Currently, most economists recommend cutting government expenditures rather than hiking taxes as the most growth friendly strategy. However, as Batini et al. point out, depending on the economic environment, this can turn out to be a dangerous piece of advice.
In a recession, cutting government outlays proves to be rather detrimental to growth. According to the results, the fiscal multiplier for so-called expenditure shocks varies between 1.6 and 2.6. This means that every Euro of cuts costs 1.60 to 2.60 Euro of GDP. Tax hikes are significantly less harmful: The fiscal multiplier only ranges between 0.16 and 0.35.
Unfortunately, however, most crisis countries in the Euro area heeded the prevalent economic advice and gave a higher priority to cuts rather than to tax hikes, as Laura Weymes, an economist with the Central Bank of Ireland, recently stressed in a paper:
“Currently, the composition of consolidation programs across the broader EU appear balanced slightly in favour of expenditure.”
This might have exacerbated Europe’s problems.
Angela, please listen.