The “Austerity Myth”: Gain without Pain?
Roberto Perotti (University of Bocconi) | November 2011
As governments around the world contemplate slashing budget deficits, the “expansionary fiscal consolidation hypothesis” is back in vogue. I argue that, as a statement about the short run, it should be taken with caution. Alesina and Perotti (1995) and Alesina and Ardagna (2010) (AAP) show that fiscal consolidations may be expansionary if implemented mainly by cutting government spending. IMF (2010) criticizes the data and methodology used by AAP, and reach opposite conclusions. I argue that because of the multi-year nature of the large fiscal consolidations, which are precisely the most informative ones, using yearly panels of fiscal policy is limiting. I present four detailed case studies, two — Denmark and Ireland — undertaken under fixed exchange rates (the most relevant case for many Eurozone countries today) and two — Finland and Sweden — after floating the currency. All four episodes were associated with an expansion; but only in Denmark the driver of growth was internal demand. However, after three years a long slump set in as the economy lost competitiveness. In all the others for a long time the main driver of growth was exports. In Ireland this occurred because the sterling coincidentally appreciated. In Finland and Sweden the currency experienced an extremely large depreciation after floating. In all consolidations interest rate fell fast, and wage moderation played a key role in generating a gain in competitiveness and a decline in interest rates. Wage moderation was facilitated by the direct intervention of the government in the wage negotiation process. In Finland and Sweden, the adoption of inflation targeting at the same time of the consolidation helped the decline in interest rates. These results cast doubt on at least some versions of the expansionary fiscal consolidations hypothesis, and on its applicability to many countries in the present circumstances. A depreciation is not available to EMU members today (except vis à vis countries outside the Eurozone). A net export boom is not feasible for the world as a whole. A further decline in interest rates is unlikely in the current situation. And incomes policies are not popular nowadays; moreover, international experience, and the Danish case, suggest that they are ineffective after a few years.

Is the Recovery Sustainable?
Dimitri Papadimitriou (Bard College), et al. | December 2011
Fiscal austerity is now a worldwide phenomenon, and the global growth slowdown is highly unfavorable for policymakers at the national level. According to our Macro Modeling Team’s baseline forecast, fears of prolonged stagnation and a moribund employment market are well justified. Assuming no change in the value of the dollar or interest rates, and deficit levels consistent with the Congressional Budget Office’s most recent “no-change” scenario, growth will remain very weak through 2016 and unemployment will exceed 9 percent. In an alternate scenario, the authors simulate the effect of new austerity measures that are commensurate with the implementation of large federal budget cuts. Here, growth falls to 0.06 percent in the second quarter of 2014 before leveling off at approximately 1 percent and unemployment rises to 10.7 percent by the end of 2016. In their fiscal stimulus scenario, real GDP growth increases very quickly, unemployment declines to 7.2 percent, and the US current account balance reaches 1.9 percent by the end of 2016—with a debt-to-GDP ratio that, at 97.4 percent, is only slightly higher than in the baseline scenario. An export-led growth strategy may accomplish little more than drawing a small number of scarce customers away from other exporting nations, and the authors expect no net contribution to aggregate demand growth from the financial sector. A further fiscal stimulus is clearly in order, they say, but an ill-timed round of fiscal austerity could result in a perilous situation for Washington.
Austerity and Anarchy: Budget Cuts and Social Unrest in Europe, 1919-2008
Jacopo Ponticelli and Hans-Joachim Voth (Universitat Pompeu Fabra) | August 2011
Does fiscal consolidation lead to social unrest? Using cross-country evidence for the period 1919 to 2008, we examine the extent to which societies become unstable after budget cuts. The results show a clear correlation between fiscal retrenchment and instability. We test if the relationship simply reflects economic downturns, and conclude that this is not the case. While autocracies and democracies show a broadly similar responses to budget cuts, countries with more constraints on the executive are less likely to see unrest after austerity measures. Growing media penetration does not strengthen the effect of cut-backs on the level of unrest.
Is Ireland Really the Role Model for Austerity?
Stephen Kinsella (University of Limerick) | September 2011
This paper describes the causes and consequences of Ireland’s economic crisis in the context of the policy solution implemented to contain that crisis: protracted fiscal austerity. I describe the causes of the recent crisis in Ireland, and look at the logic of austerity with a simple model. I compare the current crisis to the crisis of the 1980s, when fiscal austerity was touted as the trigger for the Celtic Tiger. I discuss the measures implemented to date in the current crisis, tracing their effects on sectors of Ireland’s macroeconomy, and, finally, ask whether Ireland is, indeed, the role model for fiscal austerity in the Eurozone and beyond.
Expansionary Austerity New International Evidence
Jaime Guajardo (IMF), et al. | July 2011
This paper investigates the short-term effects of fiscal consolidation on economic activity in OECD economies. We examine the historical record, including Budget Speeches and IMFdocuments, to identify changes in fiscal policy motivated by a desire to reduce the budget deficit and not by responding to prospective economic conditions. Using this new dataset, our estimates suggest fiscal consolidation has contractionary effects on private domestic demand and GDP. By contrast, estimates based on conventional measures of the fiscal policy stance used in the literature support the expansionary fiscal contractions hypothesis but appear to be biased toward overstating expansionary effects.
Fiscal Policy in an Era of Austerity
David Schizer (Columbia Law School) | October 2011
We face a time of stagnant economic growth, severe unemployment, massive budget deficits, and an increasingly competitive global economy. Monetary policy is tapped out, and there is a great deal of uncertainty about the effectiveness of a traditional Keynesian stimulus – and, not surprisingly, a heated debate among economists. One thing we do know is that a stimulus is quite difficult to execute effectively. For example, it is a challenge to identify “shovel ready” projects that contribute to long-term economic growth, particularly on short notice. There is no uncertainty, though, about the need to address a broad range of specific problems contributing to our economic woes. As an illustrative example, this Article emphasizes the perils of having the highest corporate tax rate in the Organisation for Economic Co-operation and Development (“OECD”) in a competitive global economy. Cutting our corporate tax rate will encourage businesses to invest and hire more employees, while also reducing incentives to engage in wasteful tax planning and to shift taxable income and jobs overseas.
Let Them Eat Cake: Socio-Economic Rights in an Age of Austerity
Paul O’Connell (University of Leicester) | August 2011
The argument advanced here, in a nutshell, is that this current age of austerity should not be viewed, as it is often cast, as exceptional, but should instead be understood as the natural order with respect to government attitudes to socio-economic rights. To put it slightly differently: in the context of an economic and social system which invariably privileges numerically small, elite groups within society, both at the domestic and global level, commitments to socio-economic rights are only ever formal, and honoured in the most grudging and limited of ways. Or, returning to the title of this chapter, in an economic and political order premised on the privileging of the few at the expense of the many, governments are happy to agree to allow everyone to “eat cake”, so long as each atomistic market actor is ready to secure it for his or herself. One important consequence of this, is that the language of socio-economic rights, and consequently the various interests related to and protected by them, tends not to feature in decision-making processes about the size and share of the national resources cake. Therefore, in seeking to take what silver lining their may be from the current crisis, we need to look at ways of democratising such decision-making processes, to provide at least the possibility that socio-economic rights, and the interests associated with them, will figure in the calculus.
Eurozone Sovereign Debt Crisis
Serge L. Wind (NY University) | November 2011
The eurozone, composed of 17 countries which have adopted the euro as their currency, has been struggling with an apparently-intractable crisis over the enormous debts faced by its weakest economies and by countries impacted by the bursting of the housing boom in the past global recession of 2007-09. “Fiscally-distressed” countries now include Italy and Spain, both too big to bail out, along with Greece, Ireland and Portugal. Major contributing factors are the sizes of net government debt, primary budget deficits and negative current account (trade) balances, each expressed as a percent of GDP. With potential loss of access to bond markets, inability to devalue and failure of the European Central Bank (ECB) to intervene, stern demands by Germany for adoption of severe austerity programs and reform could lead to a deeper recession, bond restructurings, bailouts, and even defaults on sovereign debt. The only resolution now apparently demanded by bond markets and deficit hawks is unequivocal confirmation of the ECB as lender-of-last-resort for Italy and Spain. However, Germany’s leaders are firmly opposed to expansion of ECB’s role due to concerns of inflation, devaluation of its assets, and moral hazard (rewarding risky behavior’s losses). Quickly-moving bond markets may provide a stern test of the slowly-unfolding, “just-in-time” crisis management led by Germany, which currently is proposing a “fiscal union” with enforceable deficit limits. Underlying structural factors associated with peripheral eurozone countries – overspending, imports exceeding exports, higher real labor costs, lower productivity, real appreciation, tax avoidance and the reluctance to radically reform – reflect national traits and behavior which may be difficult to change quickly. Over 40 charts support paper’s observations.