Fiscal Consolidation: Striking the Right Balance

IMF Blog, May 8, 2012

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Author: David Lipton
Date: May 8, 2012
Context: Debate on austerity vs. growth amid low growth, high debt, and rising unemployment; multiple countries engaging in simultaneous fiscal consolidation; monetary policy in most advanced economies approaching technical limits; weak global growth.
Core tradeoff: Need to reduce debt levels vs. short-term growth costs of fiscal consolidation.

Historical role: Growth has played the key role in reducing debt-to-GDP ratios.
Policy priorities to support growth:
- Monetary policy should remain clearly supportive of economic activity, given low or declining inflationary pressures in most advanced economies.
- Banks need to recapitalize so deleveraging stops being a brake on growth.
- Structural reforms need to be accelerated to boost medium-term growth.
Rationale: Ultimately it is growth that will make the difference between successful and failed consolidation.
Global employment and growth context:
- "More than 200 million people out of work worldwide."
- Growth in advanced countries forecast at "a mere 1½ percent for 2012."

Necessity: "There is no getting around the need to reduce debt levels."
Debt context: Public debt-to-GDP ratio "has reached a peak seen only once before during the past 130 years—during the Second World War."
General principle for pace:
- Adjustment should be conducted in the context of well-specified medium-term plans.
- Adjustment should be at a steady "underlying pace" that balances bringing down deficits against not undermining the recovery.
- "Underlying pace" means the adjustment path should be defined irrespective of cyclical fluctuations in output.
Country differentiation:
- Countries with weaker fiscal accounts should adjust more rapidly.
- Frontloaded and fast adjustment should be limited to countries where financing constraints leave no other option.

Current assessment:
- "Adjustment is proceeding reasonably in all advanced economies this year."
- The current rate of deficit reduction in advanced economies is "about 1 percent of GDP annually on average."
- For 2013, the degree of planned adjustment in most countries is "largely appropriate."
Notable exceptions and risks:
- United States: "Fiscal tightening will be excessive if current legislation is not amended—hence the talk of a 'fiscal cliff.'"
- 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."
Recalibration guidance:
- If conditions worsen, countries should stick with announced measures but not necessarily with nominal targets.
- Do not fight 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.
- Caveat: Fiscal policy is not well suited to fine tune responses to small shocks, and changes in fiscal policies involve costs to credibility.
- The underlying pace of adjustment may need reconsideration if headwinds from simultaneous public and private deleveraging prove substantially larger than anticipated or if there are further large adverse shocks.

Time horizon: "Even under optimistic assumptions, it will take many years for debt ratios to return to more appropriate levels."
Credibility requirements:
- 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 in the current environment.
Specific country observations:
- United States and Japan "lack sufficiently detailed and ambitious medium-term plans to reduce their debt ratios."
- European countries: Broad plans under the "fiscal compact" exist, but "in some cases the measures needed to accomplish the targets still need to be spelled out."
Composition of adjustment:
- The starting point matters for spending vs. revenue composition.
- General suggestion: European countries should focus more on spending cuts, which tend to be more sustainable in the longer term.
- United States: "Relatively low levels of spending in the U.S. suggest more room to act on the revenue side."

IMF stance since the start of consolidation phase: Advice has been in line with the general principles described—calling for more or less fiscal adjustment depending on whether adjustment was proceeding with insufficient vigor or excessive zeal given growth outlook and financing conditions.
Ongoing approach:
- Continue to work with member countries to design policy mixes right for their circumstances.
- Seek to ensure that the sum of country policies does not derail the fragile global recovery.
- Emphasize flexibility: avoid dogmatism and be ready to adapt policy responses if conditions warrant it.
Timing reference: "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."

Source: Fiscal Consolidation: Striking the Right Balance — David Lipton, May 8, 2012

IMFC Statement by Jun Azumi, Minster of Finance, Japan; April 21, 2012
- IMFC Statement by Jun Azumi, Minster of Finance, Japan; April 21, 2012 (Markdown version)
- IMFC Statement by Jun Azumi, Minster of Finance, Japan; April 21, 2012 (PDF)