Austerity Debate a Matter of Degree

The Wall Street Journal

In Europe, Opinions Differ on Depth, Timing of Cuts; International Monetary Fund Has Change of Heart

In the U.S., the debate about whether the government should start cutting its budget deficit opens up a deep ideological divide. Many countries in Europe don't have that luxury.

True, there may be questions about how hard to cut budgets and how best to time the cuts, but with government-bond investors going on strike, policy makers either don't have a choice or feel they don't. Budget austerity is also a recipe favored by Germany and other euro-zone governments that hold the Continent's purse strings

Once upon a time, the International Monetary Fund, which also provides bailout funds and lend its crisis management expertise to euro-zone governments, would have been right there with the Germans: It never handled a financial crisis for which tough austerity wasn't the prescribed medicine. In Greece, however, officials say the IMF supported spreading the budget pain over a number of years rather than concentrating it at the front end.

That is partly because overpromising the undeliverable hurts government credibility, which is essential to overcoming the crisis. But it is also because the IMF's view has shifted.

"Over its history, the IMF has become less dogmatic about fiscal austerity being always the right response to a crisis," said Laurence Ball, economics professor at Johns Hopkins University, and a part-time consultant to the IMF.

These days, the fund worries more than it did about the negative impact that cutting budgets has on short-term growth prospects—a traditional concern of Keynesian economists.

"Fiscal consolidation typically has a contractionary effect on output. A fiscal consolidation equal to 1% of [gross domestic product] typically reduces GDP by about 0.5% within two years and raises the unemployment rate by about 0.3 percentage point," the IMF said in its 2010 World Economic Outlook:

But that isn't the full story. In the first place, the IMF agrees that reducing government debt—which is what austerity should eventually achieve—has long-term economic benefits. For example, in a growing economy close with strong employment, reduced competition for savings should lower the cost of capital for private entrepreneurs.

That suggests that, where bond markets give governments the choice, there is a legitimate debate to be had about timing of austerity. The IMF economic models suggest it will be five years before the "break-even" point when the benefits to growth of cutting debt start to exceed the "Keynesian" effects of austerity.

There is an alternative hypothesis that has a lot of support in Germany, and among the region's central bankers. This is the notion that budget cutbacks stimulate growth in the short term, often referred to as the "expansionary fiscal contraction" hypothesis.

Manfred Neumann, professor emeritus of economics at the Institute for Economic Policy at the University of Bonn, said the view is also called the "German hypothesis" since it emerged from a round of German budget cutting in the early 1980s.

The positive effect of austerity is much stronger than most people believe," he said. The explanation for the beneficial impact is that cutting government debt generates an improvement in confidence among households and entrepreneurs, he said.

The IMF concedes there may be something in this for countries where people are worried about the risk that the government might default—but only up to a point. It concedes that fiscal retrenchment in such countries "tends to be less contractionary" than in countries not facing market pressures—but doesn't conclude that budget cutting in such circumstances is actually expansionary.

Each side of the debate invokes its own favored study. Support for the "German hypothesis" comes from two Harvard economists with un-German names—Alberto Alesina and Silvia Ardagna. But their critics, who include Mr. Ball, say their sample includes many irrelevant episodes for which their model fails to correct—including, for example, the U.S. "fiscal correction" that was born out of the U.S. economic boom of the late 1990s.

Mr. Alesina didn't respond to an email asking for comment, but Mr. Neumann said he isn't confident that studies, such as the IMF's, that appear to refute the hypothesis manage to isolate the effects of the austerity policy from other effects of a financial crisis.

Some of the IMF's conclusions, however, bode ill for the euro zone's budget cutters.

The first is that the contractionary effects of fiscal retrenchment are often partly offset by an increase in exports—but less so in countries where the exchange rate is fixed. Second, the pain is greater if central banks can't offset the fiscal austerity through a stimulus in monetary policy. With interest rates close to zero in the euro zone, such a stimulus is hard to achieve. Third, when many countries are cutting budgets at the same time, the effect on economic activity in each is magnified.

If you are a government in budget-cutting mode, there are, however, better and worse ways of doing it. The IMF says spending cuts tend to have less negative impact on the economy than tax increases. However, that is partly because central banks tend to cut interest rates more aggressively when they see spending cuts.

Mr. Neumann sees an austerity hierarchy. It is better to cut government consumption and transfers, including staff costs, than government investment—though it may be harder politically. If you are raising taxes, better to raise those with no impact on incentives—such as inheritance or wealth taxes—than those that hurt incentives, such as income or payroll taxes.

Raising sales or value-added taxes may have less impact on incentives—but have other undesirable effects, such as increasing inflation, that could deter central banks from easing policy.

Write to Stephen Fidler at stephen.fidler@wsj.com