The debate on austerity vs. growth has gained in intensity, as countries in Europe and elsewhere struggle with low growth, high debt, and rising unemployment. In essence, policymakers are being asked to tackle a continuation of the worst crisis since the Great Depression.
This would be no easy task under any circumstances. But it is made considerably harder by the fact that a number of countries need to engage in fiscal consolidation simultaneously. Complicating the picture further is the fact that monetary policy in most advanced economies is approaching the limits of what it technically can do to stimulate activity, while global growth remains weak.
There is no getting around the need to reduce debt levels. High debt leaves countries exposed to interest rate shocks, limits their capacity to respond to future shocks, and reduces long-term growth potential.
At the same time, we all know that fiscal consolidation―reducing deficits by cutting spending or raising revenues―can and usually does stifle growth. With more than 200 million people out of work worldwide, and with growth in advanced countries forecast at a mere 1½ percent for 2012, getting the pace of consolidation right is therefore of paramount importance. So how do policymakers strike the right balance?
As IMF Managing Director Christine Lagarde pointed out the other day, the growth vs. austerity debate is essentially a false one. There can be no lasting growth without sustainable policies, and right now that sustainability requires fiscal consolidation. But equally there can be no sustainable adjustment without growth.
So the critical challenge is to devise a strategy that is good for stability and good for growth. This is possible. But there is no denying that, in the short term, consolidation involves real costs and requires tough choices, the more so given that growth is already below potential and there is little scope for additional lift from monetary policy or external demand.
Growth is essential
Let us also not forget that in the past, growth has played the key role in reducing debt-to-GDP ratios. Policies aimed at enhancing growth should therefore be at the forefront of our thinking and should play their part: with inflationary pressures low or declining in most advanced economies, monetary policy should remain clearly supportive of economic activity, banks need to recapitalize so deleveraging stops being a brake on growth, and structural reforms need to be accelerated to boost medium-term growth.
Ultimately it is growth that will make the difference between successful and failed consolidation. Concerted action at the regional and global level can help.
Striking the right balance
Right now, practically every country within the European Union, plus many advanced economies in other parts of the world, need fiscal consolidation. The public debt-to-GDP ratio has reached a peak seen only once before during the past 130 years—during the Second World War. So in most advanced countries debt must come down and for that so must deficits.
A key practical question is, how fast?
The general principle to answer this question is that adjustment should be conducted in the context of well-specified medium-term plans, at a steady underlying pace that balances the need to bring down deficits against that of not undermining the recovery.
"Underlying pace" is worth stressing. It means that the adjustment path should be defined irrespective of cyclical fluctuations in output. Within that overall approach, there is scope for significant country by country differentiation: for countries where fiscal accounts are weaker, adjustment should occur more rapidly. Frontloaded and fast adjustment should be limited to countries where financing constraints leave no other option.
Are we on the right course?
From this perspective, adjustment is proceeding reasonably in all advanced economies this year. The current rate of deficit reduction in advanced economies, about 1 percent of GDP annually on average, seems about right.
For 2013, the degree of planned adjustment in most countries is also largely appropriate. A notable exception is the United States, where fiscal tightening will be excessive if current legislation is not amended—hence the talk of a “fiscal cliff.” Also, in a few euro area countries, the nominal fiscal targets for 2013 agreed before the current slowdown in growth may prove too pro-cyclical and may need to be adjusted or at least expressed in structural terms.
But all should be prepared for a possible need to recalibrate. If conditions worsen, countries should stick with their announced measures, but not necessarily with their nominal targets. That means not fighting the automatic stabilizers, the reduction in revenue and increase in spending that comes about solely because of lower growth.
If the outlook turns out much worse, policies might need to be recalibrated to be more supportive of growth. Of course, fiscal policy is not really suited as a tool to fine tune responses to small shocks, and changes in fiscal policies involve costs to credibility. But the underlying pace of adjustment may need to be reconsidered if headwinds from simultaneous public and private deleveraging prove substantially larger than anticipated or if there are further large adverse shocks.
Sustaining the effort
Even under optimistic assumptions, it will take many years for debt ratios to return to more appropriate levels.
Clear medium-term plans based on specific measures and backed by strong fiscal frameworks are key to establish credibility. Vagueness about adjustment plans would have a damaging impact on any country’s credibility, particularly in this environment.
In that respect, it’s worth noting that both the United States and Japan lack sufficiently detailed and ambitious medium-term plans to reduce their debt ratios. And while countries in Europe all have broad plans in place under the "fiscal compact", in some cases the measures needed to accomplish the targets still need to be spelled out.
In this connection it is also important to pay attention to the composition of the adjustment effort between spending and revenue measures. Here the starting point matters. In general it suggests European countries should focus more on spending cuts, which tend to be more sustainable in the longer term; while relatively low levels of spending in the U.S. suggest more room to act on the revenue side.
Looking ahead
Since the start of the consolidation phase of the crisis two years ago, the IMF advice has been in line with the general principles mentioned at the outset. We have called for more or less fiscal adjustment depending on whether we felt fiscal adjustment was proceeding with insufficient vigor or excessive zeal given the growth outlook and financing conditions.
Looking ahead, we will continue to work with our member countries and help them come up with a policy mix that is right for their particular circumstances, while trying to ensure that the sum of country policies do not derail the fragile global recovery that’s currently underway.
This is not a good time, if ever there is one, to be dogmatic in our response to challenges. Rather we need to keep an open mind and be ready to adapt our policy responses if conditions warrant it.
