IMF Survey: Budget Cuts and Growth: Short-term Pain, Long-term Gain
IMF News, September 30, 2010
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Bibliographic details
- Published: September 30, 2010
Main findings
- Almost all advanced economies will need to cut deficits and raise taxes to put their fiscal positions back on a sustainable footing in the coming years.
- Initial fiscal retrenchment typically has contractionary short-term effects on economic activity, with lower output and higher unemployment, but is likely to be beneficial over the longer term.
- Lower debt is likely to reduce real interest rates and the burden of interest payments, allowing for future cuts to distortionary taxes and boosting private investment and long-term output.
Short-term effects and magnitudes (chapter: “Will It Hurt? Macroeconomic Effects of Fiscal Consolidation”)
- Within two years of cutting the budget deficit by 1 percent of GDP:
- Domestic demand—consumption and investment—is about 1 percent lower.
- The unemployment rate is about ⅓ percentage point higher.
- Net exports tend to rise, and the overall impact on GDP is a decline of ½ percent.
Factors that soften the short-term impact
- Central banks usually cut interest rates and the currency falls in value, cushioning consumption and investment and boosting exports.
- Consolidation is less costly when markets are more concerned about fiscal sustainability.
- Consolidations based on spending cuts are less painful than those based on tax hikes, largely because central banks cut interest rates more after spending cuts.
Today's environment and scenarios
- In the current environment described in the chapter:
- Fiscal consolidation is likely to have more negative short-term effects than usual because many central banks can only provide limited monetary stimulus with interest rates already near zero.
- If many countries adjust simultaneously, output costs are likely to be greater since not all countries can reduce the value of their currency and increase net exports at the same time.
- Fiscal retrenchment is likely to be more costly for members of a monetary union where scope for a fall in the value of their currency is reduced.
- Simulations suggest the contraction in output may be more than twice as large as the IMF’s baseline estimate when central banks cannot cut interest rates, and when the adjustment is synchronized across all countries.
- For economies considered at high risk of sovereign default, short-term negative effects are likely to be smaller.
Policy recommendations and measures to reduce impact on recovery
- Implement measures that are legislated now but only reduce deficits in the future—when the recovery is more robust.
- Examples provided:
- Linking statutory retirement ages to life expectancy.
- Improving the efficiency of entitlement programs.
IMF Survey online, September 30, 2010