Autor: Daniel Gros, Director of the Centre for European Policy Studies, Brussels
With European governments cutting back on spending, many are asking whether this could make matters worse. In the UK for instance, recent OECD estimates suggest that ‘austerity’ will lead to another recession, which in turn may lead to a higher debt-to-GDP ratio than before. As the debate heats up, this column provides some cool economic logic.
Could ‘austerity’ be self-defeating? Could a reduction in government expenditure lead to such a strong fall in activity that fiscal performance indicators actually get worse?
It is sometimes argued that a cut in expenditure (or an increase in taxes) would be self-defeating because it reduces demand so much that tax revenues fall so strongly that as a result the deficit actually increases. In standard models this is kind of ‘Laffer curve’ effect is actually not possible. Moreover, if it were true, it would follow that an increase in expenditure could actually lead to lower deficits because higher growth could increase tax revenues so much that they outweigh the increase in expenditure. This proposition has been tested several times in the US, and always found failing.
Can austerity raise debt/GDP ratios?
In Europe the concern today is instead with the debt/GDP ratio. The perspective here is that ‘austerity’ might be self-defeating in the sense that the resulting GDP drop is so large that the debt/GDP ratio increases. This matters since the debt/GDP ratio is often taken by financial markets as an indicator of the sustainability. Thus a lower deficit might actually heighten tensions in financial markets.
Here I show that this sort of outcome could indeed occur, but only in the short run. Over the medium to long run, the debt/GDP ratio must improve even if deficit cutting lowers GDP. Anticipating the results of the reasoning, it can be shown in a standard model that in the short run a fiscal adjustment can be self-defeating if the product of the starting debt/GDP ratio and the multiplier (of fiscal policy on output) exceeds one. (See Annex for details.)
For example, this condition might be satisfied for countries with debt/GDP ratio higher than 100% if we believe certain ‘Keynesian’ models with fiscal multipliers that exceed one (ie the impact of higher expenditure on output is larger than the amount of expenditure itself). However, in most ‘neo-Keynesian’ models the ‘multipliers’ are often considerably lower than this. If these models describe reality better it is unlikely that austerity could be self-defeating – even in the short run.
Simple calculations
Here is how the short-run self-defeating mechanism could work. Assume Italy – with its debt/GDP ratio of 120% reduces its deficit by 1% of GDP by cutting public expenditure.
If the multiplier is 1.5, the spending cut would lower GDP 1.5%.
The GDP drop would – on its own – increase the debt/GDP ratio by 1.8 percentage points.
But this is more than the reduction in the debt achieved directly by the cut in expenditure.
The long-run calculation is slightly more involved. There are two reasons for the general result that a fiscal adjustment cannot be self-defeating in the long run:
First, most models assume that a cut in expenditure lowers demand in the short run, but that the economy recovers after a while to its previous path.
In this case, the debt/GDP will be lower in the long run since GDP returns to path but debt does not – it remains lower than it would have been without the austerity.
It follows that any short-run increase in debt/GDP due to the short-run fall in demand must be fully compensated in the long run. Therefore the long-run impact of a lower deficit on debt/GDP is equal to the reduction in the deficit itself.
Second, assuming both the cut in public expenditure and its impact on GDP are permanent, debt/GDP must improve in the long run.
The basic point is simple. The permanent deficit cut lowers the growth rate of debt, while the permanent impact on GDP is of the path-lowering type, not the growth-lowering type. Thus any initial increase in debt/GDP will be reversed over time.
Of course an even more extreme version would have it that permanent deficit cuts reduce the long-run growth rate, but this is not a result found in even the most extreme Keynesian models.
Does the short or long run matter?
The key question in the context of the current Eurozone crisis is thus whether financial markets focus on the short run or long run. Prospective buyers of Italian one-year bonds should look at the longer-run impact of deficit cutting on the debt level, which is pretty certain to be positive. Of course, if markets are not rational and react only to the short-run effect the result might be different.
Policy conclusions
So what should governments do? Abandon austerity because financial markets might be shortsighted? This would only delay the day of reckoning as debt ratios would increase in the long run.
A country which enters a period of heightened risk aversion with a large debt overhang faces only bad choices.
Implementing credible austerity plans constitutes the lesser evil, even if this aggravates the cyclical downturn in the short.
All in all, the conclusion is that it difficult to argue that the peripheral countries in the Eurozone should abandon attempts to reduce their deficits because the results will arrive only in the long run (de Grauwe 2011).
Lo que comentamos es que si realmente en un país como España o Italia la simple austeridad bastará para que la economía crezca.
