Don’t cut spending in a recession, try it in an upturn if you can and make sure when you cut there’s a credible tax increase in the mix. It makes the job easier and helps the economy, not flattens it more than it already is.
This advice to governments contemplating austerity measures, or fiscal consolidation, is contained in a working paper prepared by a trio of International Monetary Fund economists and released last month. The paper further warns governments that if they cut very deeply, the chances of a recession are “more likely even when made at an expansion time” in an economy.
It’s a timely warning for America’s squabbling politicians as that country stares down the so-called “fiscal cliff” on January 1 of the ending of the Bush tax cuts (hence a big increase in taxes) and a sharp $US400 billion cut in federal spending, all at once. It is also a nudge for the opposition parties in Australia with their plans for spending cuts and the abolition of taxes (the mining and carbon tax) should they win government next year. Badly done, or the wrong mix, can plunge even a solid economy into a slowdown.
As well, governments are advised not to limit their consolidation to just cutting government spending; other measures such as moves to boost tax revenues should be part of the plan, which should be “a balanced composition of spending cuts and tax increases in a gradual fiscal adjustment”. Such a mix “boosts the chances that the consolidation will successfully (and rapidly) translate into lower debt-to-GDP ratios. Monetary policy can likely help alleviate further the pain of fiscal withdrawal if it is used proactively via reduction in the real interest rate”. Governments should also not lose sight of the fact that framing a credible program of fiscal consolidation can be a big help by improving market confidence.
Get Crikey FREE to your inbox every weekday morning with the Crikey Worm.
The bailouts of Greece, Portugal and Ireland have stressed both, but both were started in a slowdown and have extended to a very deep recession (although Ireland is showing some signs of growing). Italy and Spain have tried to do both in their fiscal consolidations, but they have only made the slowdowns deeper and lifted unemployment dramatically. There has been much talk of a gradual program in all countries but none have turned out that way — the impact has been front loaded and extremely damaging.
Called Successful Austerity in the United States, Europe and Japan, the findings of the paper also gives us an idea why the fiscal consolidation in the UK is not working as it was planned to, with the UK economy now in its second recession since 2008 and facing rising government borrowings at a time when they were supposed to be falling. It also helps to understand why the programs in Greece, Spain, Italy and Portugal have been self-defeating so far. In fact the paper warns governments that “front-loading consolidation risks bringing recoveries to a halt, hindering the same fiscal adjustment or making it too costly in terms of jobs and output”.
With the federal opposition eyeing government at next year’s poll, the findings of this paper should be a warning to Joe Hockey and Tony Abbot about what not to do when the claim they will hacking federal spending by $70 billion. There’s a small chance the economy could be weaker this time next year and into 2014 as the investment boom cools, the world economy and especially China enjoy sluggish to little growth and commodity prices remain weak. The growth trajectory and momentum in the Australian economy could be very much different in a year’s time and into 2014, requiring stability on the fiscal side and not a shock.
Given that the federal opposition is committed to abolishing the carbon and mining taxes, and cutting spending, there’s every chance the impact on the economy could be double sided, pushing growth lower or halting it all together.