hero working papers

The 'Austerity Mith': Gain without Pain?

Number: 430
Year: 2011
Author(s): Roberto Perotti
As governments around the world contemplate slashing budget deficits, the "expansionary fiscal consolidation hypothesis" is back in vogue. I argue that, as a statement about the short run, it should be taken with caution. Alesina and Perotti (1995) and Alesina and Ardagna (2010) (AAP) have argued that, contrary to conventional wisdom, fiscal consolidations may be expansionary if implemented mainly by cutting government spending. IMF (2010) criticizes the data used by AAP and shows that all consolidations are contractionary in the short run. I argue that this criticism is correct in principle, and that there are other important limitations in the AAP methodology. However, the implementation of the IMF methodology has several problems of its own, that make an interpretation of the IMF results difficult. I then argue that because of the multi-year nature of the large fiscal consolidations, which are precisely those that can tell us more on the mechanisms at work, using yearly panels of annual data is limiting. I present four detailed case studies of fiscal consolidations, two (Denmark and Ireland) carried out under fixed exchange rates (arguably the most relevant case for many European countries today) and two (Finland and Sweden) after floating the currency. All four consolidations were associated with an expansion; but only in Denmark the driver of growth was internal demand. However, as in most exchange rate based stabilizations, after three years a long slump set in as the economy lost competitiveness. In the other episodes for a long time the main driver of growth was exports. In the second exchange rate based stabilization, Ireland, this occurred because the sterling coincidentally appreciated. In Finland and Sweden the currency experienced an extremely large depreciation after floating. In all consolidations interest rate fell fast, and wage moderation played a key role in ensuring competitiveness and allowing the decrease in interest rates. Wage moderation was supported by incomes policies that saw the direct in tervention of the government in the wage negotiation process. These results cast doubt on at least some versions of the "expansionary fiscal consolidations" hypothesis, and on its applicability to many countries in the present circumstances. A depreciation is not available to EMU members today (except vis a vis countries outside the Eurozone). The current account channel is not available to the world as a whole. A further decline in interest rates is unlikely in the current situation. And incomes policies are not popular nowadays; moreover, international experience, and the Danish case, suggest that they are ineffective after a few years.