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Analysis

Front-Loaded Stimulus, Back-Loaded Austerity: The Optimal Fiscal Austerity Path and the Risks of Other Routes

By Nouriel Roubini

EXECUTIVE SUMMARY

The fiscal stimulus implemented by numerous countries during the global recession was a significant factor in warding off further economic decline. However, the stimulus inevitably led to large fiscal deficits in most advanced economies and, in turn, to programs of severe fiscal consolidation.

The question is, how does one balance the trade-off between the benefits that austerity measures have on a country’s debt level with their recessionary and deflationary side effects?

For a number of reasons, the main advanced economies are mostly following sub-optimal fiscal paths or, in some cases, paths that are precisely the opposite of what would be desirable. This paper argues that the optimal path of fiscal austerity would, in most countries, imply a back-loaded but credible commitment to medium-term fiscal consolidation, together with short-term additional stimulus when necessary and allowed by market conditions, and/or some degree of short-term austerity. Notably, such short-term austerity would not be front-loaded in order to avoid the risks of a deflationary and recessionary spiral.

Unsustainable Public Debt and Deficits in Advanced Economies

The fiscal stimulus that most advanced and emerging market economies implemented during the 2008-09 global recession prevented the Great Recession from turning into another Great Depression (together with monetary easing and the backstopping of the financial system). At a time when every component of private demand was falling—consumption, investment, exports—the boost from higher government spending and transfers and lower taxes stopped the freefall of the global economy and provided the foundation for recovery.

Unfortunately, this fiscal stimulus and the related fiscal bailout of the financial system led to large fiscal deficits—of the order of 10% of GDP—in most advanced economies and will lead—according to IMF and other estimates—to public debt-to-GDP ratios in these economies rising to above 110% by 2015 from 70% before the crisis. While these deficits are in part cyclical as growth has not recovered to trend, the painful process of private debt deleveraging implies that growth rates will remain low for a number of years. Thus, the deficits are also structural and will not fall even if trend growth (or, for a while, above-trend growth) is achieved.

The ageing of populations in most advanced economies adds to the long-term public debt burden with unfunded pension plans and the rising cost of health care for the elderly adding to the implicit liabilities of the public sector. Thus, in most advanced economies, current fiscal policy is on an unsustainable path and deficits need to be reduced over time to avoid a fiscal train wreck.

However, studies—such as a recent one by the IMF for the September World Economic Outlook— suggest that while fiscal austerity may be necessary to avoid a fiscal train wreck in the short run, raising taxes—and thus reducing disposable income—and reducing government spending, subsidies and transfer payments has a negative short-term effect on aggregate demand, and thus is deflationary and recessionary.

Optimal Path of Fiscal Consolidation

So, how does one square the need for medium-term fiscal consolidation with the problem that such consolidation/austerity is recessionary in the short run? In an ideal world, where fiscal policy makers can credibly commit to medium-to-long term adjustment, the optimal and desirable path of fiscal adjustment would be the following: commit today to a schedule of gradual reductions in government spending—including reforms of social security plans and medical spending—that will be phased in gradually but progressively over the next decade or more and a schedule of increases in tax revenues—preferably less distortionary ones such as a carbon tax or a VAT/sales tax—that will also be phased in gradually once the economy has recovered in a more resilient way.  

Then, as long as that medium-term fiscal adjustment is credible and committed in advanced—even if the actual fiscal austerity kicks-in gradually over a decade—private investors will know that there is a fiscal light at the end of the tunnel (i.e. the stabilization of public debt ratios and reduction of structural public deficits to sustainable levels). Thus, bond market vigilantes would not punish these credibly committed but back-loaded fiscal consolidation plans. And, in the meantime, if in the short run the economy needs another targeted fiscal stimulus (while private demand and growth are still anemic), no one would punish a country that opts for additional short-run fiscal stimulus as long as the medium-term fiscal path leads to austerity, discipline and fiscal sustainability.

So, the way to square the circle is to have credible medium-term consolidation with additional short-term stimulus. Indeed, in a recent speech, even Fed chairman Ben Bernanke has called for such a fiscal consolidation path: “a fiscal program that combines near-term measures to enhance growth with strong, confidence-inducing steps to reduce longer-term structural deficits would be an important complement to the policies of the Federal Reserve.” Thus, a well-targeted temporary additional stimulus to jump start the demand for labor by the private sector and boost a sluggish real economy and labor markets would be necessary and desirable as long as concrete steps are taken at the same time to ensure medium-term fiscal discipline and sustainability.

So, bearing in mind this optimal path, what are the fiscal policy routes followed by various advanced economies?

United States

In the U.S., there is the worst of all possible worlds: the opposite of the optimal path of fiscal consolidation. Indeed, the term stimulus is already a dirty word, even within the Obama administration. After a November poll where Republicans made significant electoral gains, it is even less likely that any further stimulus will be implemented. Moreover, medium-term consolidation will be all but impossible as the 2012 presidential election begins to loom large and as the two parties are locked in a gridlock and lack of bipartisanship that is worse than ever. Republicans are vetoing any tax increases, while the Democrats are resisting reforming entitlement spending.

The gridlock in Congress will soon get much worse. Of course, Obama and his administration share the blame for this stalemate; but the Republicans have taken the Leninist approach of “the worse the better,” and offer no cooperation on any issue. That they now think that Obama will be a one-term president will soon mean the worst open warfare inside the Beltway in 30 years. Given the political climate in Washington, the chances that the recommendations of the president’s deficit commission will be implemented in 2011-12 are close to zero. And, with the bond vigilantes asleep at the wheel, there is no market pressure to start fiscal austerity.

Eurozone

The opposite problem can be seen in the periphery of the eurozone (EZ). There, the fiscal austerity is fully front-loaded: the bond vigilantes have woken up in Greece, Ireland, Portugal and Italy and they are telling these sovereigns: “we don’t care if your fiscal austerity is deflationary and recessionary; either you front-load your fiscal consolidation or we will force your sovereign spreads through the roof, make you lose market access and trigger a public and private debt rollover crisis.”

Markets don’t care that this early and front-loaded fiscal consolidation is exacerbating the recession in these economies and actually making things worse, as a continuation of a recession implies that the goal of reducing debt and deficits as a share of GDP becomes mission impossible if the fiscal austerity causes a persistent fall in output/GDP and deflation that in turn exacerbates unsustainable debt dynamics.  

To avoid a persistent and destructive recession that prevents the achievement of fiscal sustainability, fiscal and structural reforms imposed by the bond vigilantes should be accompanied by other EZ-wide policies that restore growth and prevent these vicious debt dynamics.

Those policies include:

a) massive and front-loaded official EZ/IMF support (i.e. not implemented at the last moment when conditions are desperate like in Greece and Ireland) of countries in distress to smooth the path of fiscal austerity and structural adjustment; and a much larger envelope of official resources, as the current resources of the IMF/European Financial Stability Fund (EFSF)/EU are not sufficient to bail out Spain if Portugal is—as likely—bailed out after Greece and Ireland;

b) a much easier monetary policy by the ECB to bootstrap periphery growth and to aggressively weaken the value of the euro—as a much weaker euro is essential to restore the competitiveness of the EZ periphery;

c) a short-term fiscal stimulus—not the front-loaded fiscal austerity currently chosen—by Germany in the form of temporary tax reductions—not the planned increases—to increase disposable income, stimulate consumption and thus stimulate German demand for the periphery’s goods and services;

d) plans to bail-in all unsecured creditors of EZ banks in distress to prevent the socialization of those private losses from further risking breaking the back of already burdened sovereigns; and

e) contingency plans to use coercive but orderly and market-based sovereign debt restructuring mechanisms (such as market-friendly exchange offers) as opposed to a statutory sovereign crisis resolution mechanism in the event of some sovereigns—against all odds and despite maximum fiscal effort—becoming nearly insolvent and requiring a public debt restructuring/reduction.

Unfortunately, the two biggest players in the EZ that could help a recovery of growth in the periphery—the ECB and Germany—are not following policies consistent with reaching the light at the end of the tunnel—i.e. the resumption of sustained growth—for the EZ periphery. The ECB’s monetary policy is too tight; Germany is front-loading fiscal austerity; the envelope of official resources that is available is too small—and unlikely to increase given German opposition—and used too late rather than in a pre-emptive and front-loaded manner; and Germany is pushing for market-unfriendly mechanisms to bail in the private creditors of distressed sovereigns.

Thus, the periphery of the EZ is destined for a destructive deflationary and recessionary adjustment that will exacerbate the risks of recession and lead to debt deflation, eventual defaults and, possibly, the exit from the monetary union of the distressed weaker members. And the recent bailout of Ireland (after that of Greece) has not calmed investors: rather the contagion has now spread to Portugal and Spain and even as far as Italy, Belgium and possibly France.

United Kingdom

In the UK, although the bond vigilantes did not wake up and impose front-loaded fiscal austerity, the new Conservative-Lib Dem coalition decided to follow a front-loaded path to fiscal consolidation anyway. The reasons given were several: the bond vigilantes could have soon woken up if early austerity was not implemented; the deficit was very large and the public sector bloated; and, politically, it is easier to implement tough austerity measures in the early stages of an administration when popular goodwill and political support allow greater and more painful cuts or tax raises.

Certainly, the UK was playing with fiscal fire and some commitment to earlier austerity was necessary to prevent the bond vigilantes from waking up. But the UK administration decided to massively front-load the fiscal austerity when using its strong parliamentary majority to lock-in a commitment to austerity measures that could have been phased in more gradually and in a partially back-loaded way would have been less risky and more optimal. 

The major risk of front-loaded austerity is that the painful cuts in spending, subsidies and public employment and increases in taxes will have a recessionary effect on an anemically recovering economy. By contrast, a credible early commitment to gradual fiscal consolidation to be phased in a more back-loaded manner would have reduced the risk of a double-dip recession while maintaining the authorities’ commitment to credible fiscal consolidation. The risk of the UK’s fiscal strategy is (as pointed out by Martin Wolf of the FT) analogous to that of climbing a mountain without a rope; i.e. not having a Plan B in the event of the Plan A of front-loaded fiscal austerity leading to a double-dip recession.

The only Plan B in the mind of Prime Minister David Cameron is that the Bank of England (BoE)—i.e. its governor, Mervyn King—will opt for QE2 in the event that the fiscal austerity proves recessionary. But QE2 by the BoE may not be sufficient to compensate for the recessionary risk of a front-loaded fiscal adjustment. A less risky fiscal path would have implied a more back-loaded fiscal adjustment that could have been credibly locked in by legislation now, with the path of spending cuts and tax increases to be implemented gradually over time.  

Cutting spending, reducing subsidies and shedding hundreds of thousands of public jobs early on (however necessary, given that the public sector is bloated) reduces disposable income and spending. When the private sector recovery is anemic and more private jobs are being shed, this is a risky strategy that may increase the risk of a double dip and the failure of the fiscal austerity strategy.

Conclusions

In summary, an optimal path of fiscal austerity would, in most countries, imply a back-loaded, but credible commitment to medium-term fiscal consolidation together with additional short-term stimulus when necessary and allowed by market conditions and/or some degree of short-term austerity that is not as front-loaded, to avoid the risks of a deflationary and recessionary spiral. Unfortunately, for a number of reasons, the main advanced economies are following fiscal paths that mostly diverge from the optimal path or, in some cases, are just the opposite of what would be desirable. Thus, the risk of a recessionary and deflationary adjustment that increases the chance of debt deflation and eventual disorderly sovereign and private sector defaults is rising.

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