Along with increased competition through various means—such as opening up to foreign capital—an important part of economic policies over the past three decades has been curbs on the size of the state. Privatization of some government functions has been one way to achieve this. Another is to control government spending through limits on the size on fiscal deficits and on the ability of governments to accumulate debt.
The economic history of recent decades offers many examples of such limits, such as the limit of 60 percent on the public-debt-to-GDP ratio set for countries to join the euro area (the so-called Maastricht criteria); this led many countries that were planning to join the euro area to carry out fiscal consolidation. The aftermath of the Great Recession of 2007–2009 offers a more recent example. On the one hand, it led to the most pronounced increase in unemployment the advanced countries had seen in the post–World War II period. On the other hand, it led to a significant increase in public debt, in large part due to the collapse in tax revenues as incomes fell. Other contributors to the debt buildup were the costs of financial bailouts of banks and companies, and the fiscal stimulus provided by many countries to stave off a Great Depression. As a consequence, in advanced economies public debt increased on average from 70 percent of GDP in 2007 to about 100 percent of GDP in 2011—its highest level in fifty years (Ghosh et al. 2013).
Against this backdrop, many governments started to undertake policies to reduce debt through a combination of spending cuts and tax increases. When former British Prime Minister David Cameron announced his government’s deficit-reduction plans in 2011, he said: “Those who argue that dealing with our deficit and promoting growth are somehow alternatives are wrong. You cannot put off the first in order to promote the second” (Cameron 2011).
Is there a case for countries in a situation similar to the United Kingdom’s in 2011 to pay down the public debt quickly? Two arguments are usually made in support of doing so in countries with ample fiscal space—that is, countries where there is little real prospect of a fiscal crisis. The first is that, while large adverse shocks occur rarely (the Great Depression of the 1930s and the Global Financial Crisis in more recent times), when they do occur, it is helpful to have used the quiet times to pay down the debt. The second argument is that high debt is bad for growth (because more distortive taxation is required to service a higher level of debt)—and, therefore, to lay a firm foundation for growth, paying down the debt is essential.
It is surely the case that many countries (e.g., in Southern Europe in the 2010s) have had little choice but to engage in fiscal consolidation, because developments in financial markets—the increase in their sovereign spreads (the interest rates their governments would have to pay to borrow) did not leave them the space to continue borrowing (Ghosh, Ostry, and Qureshi 2013). But the need for consolidation in some countries does not translate to all countries. Markets generally attach very low probabilities of a debt crisis in countries that have a strong track record of being fiscally responsible (Mendoza and Ostry 2008). That track record gives them latitude not to raise taxes or cut productive spending in a position of high debt, if the costs of austerity outweigh the benefits. And for countries with a strong track record, the benefit, in terms of the insurance against a future fiscal crisis, turns out to be remarkably small, even at very high debt ratios. For example, moving from a debt ratio of 120 percent of GDP to 100 percent of GDP over a few years buys very little in terms of reduced crisis risk—the probability of a crisis does not fall very much even when debt is reduced from such high levels (Baldacci et al. 2011).
But even if the insurance benefit is small, it may still be worth acquiring if the cost is sufficiently small. It turns out, however, that the cost is actually large—much larger than the benefit. The reason is the costs of the tax increases or expenditure cuts needed to bring down the debt are much larger than the reduced crisis risk from lower debt (see Ostry, Ghosh, and Espinoza 2015, for the economic model that demonstrates this point). Faced with a choice between living with the higher debt—and allowing the debt ratio to decline organically through economically growth—or deliberately running budgetary surpluses to reduce the debt, governments with ample fiscal space will do better by living with the debt.
Countries have not often heeded this advice. To the contrary, worries about the debt level have prompted numerous episodes of austerity by advanced economies over the past three decades. We show that such episodes have lowered incomes and raised unemployment over the short run to the medium run (over three to five years). Past austerity has also increased the Gini measure of inequality significantly, lowered the share of the income going to labor, and had a particularly strong impact on the long-term unemployment rate.
The measure of fiscal consolidation used in this chapter is based on previous IMF research (DeVries et al. 2011). This measure focuses on policy actions—tax hikes or spending cuts—taken by governments with the intent of reducing the budget deficit. This may seem to be the obvious thing to do but it is not the way fiscal consolidation has been measured in previous studies.
Typically, in the past, fiscal consolidation has been measured by successful budget outcomes. Specifically, the cyclically adjusted primary balance—the government’s primary balance adjusted for the estimated effects of business cycle fluctuations—is used as a measure of fiscal consolidation. The cyclical adjustment is needed because tax revenue and government spending move automatically with the business cycle. The hope is that, after this cyclical adjustment, changes in fiscal variables reflect policymakers’ decisions to change tax rates and spending levels. An increase in the cyclically adjusted budget balance would therefore, in principle, reflect a deliberate policy decision to cut the deficit.
In practice, however, budget outcomes turn out to be an imperfect measure of policy intent. One problem is that the cyclical adjustment suffers from measurement errors. In particular, it fails to remove swings in government tax revenue associated with asset price or commodity price movements from the fiscal data, resulting in changes in the balance that are not necessarily linked to actual policy changes. For example, in Ireland in 2009, the collapse in stock and housing prices induced a sharp reduction in the budget balance despite the implementation of tax hikes and spending cuts exceeding 4.5 percent of GDP.
Another problem is that the standard approach ignores the motivation behind fiscal actions. Thus, it includes years in which governments deliberately tightened policy to restrain excessive domestic demand. For example, in Finland in 2000, there was an asset price boom and rapid growth, and the government decided to cut spending to reduce the risk of economic overheating. If a fiscal tightening is a response to domestic demand pressures, it is not valid for estimating the short-term effects of fiscal policy on economic activity, even if it is associated with a sharp rise in the budget balance.
For these reasons, we measure fiscal consolidation based on policy actions. This gives us 173 episodes of consolidation for 17 OECD economies from 1978 to 2009. The magnitude of the consolidation during an episode is about 1 percent of GDP on average.
Using this more accurate measure of austerity, the evidence from the past is clear: fiscal consolidations typically have the short-run effect of reducing incomes and raising unemployment. A fiscal consolidation of 1 percent of GDP reduces inflation-adjusted incomes by about 0.6 percent and raises the unemployment rate by almost 0.5 percentage point (figure 6.1) within two years, with some recovery thereafter.
FIGURE 6.1: Effect of Fiscal Consolidation on Income and Unemployment
Fiscal consolidation reduces incomes and raises unemployment in the short run.
Note: Impact of 1 percent of GDP fiscal consolidation on GDP and unemployment.
Source: Ball, Leigh, and Loungani (2011).
The reduction in incomes from fiscal consolidations is even larger if central banks do not or cannot blunt some of the pain through a monetary policy stimulus. The fall in interest rates associated with monetary stimulus supports investment and consumption, and the concomitant depreciation of the currency boosts net exports. Ireland in 1987 and Finland and Italy in 1992 are examples of countries that undertook fiscal consolidations but where large devaluations of the currency helped provide a boost to net exports.
Unfortunately, these pain relievers are not easy to come by in today’s environment. In many economies, central banks can provide only a limited monetary stimulus because policy interest rates are already near zero. Moreover, if many countries carry out fiscal austerity at the same time, the reduction in incomes in each country is likely to be greater, because not all countries can reduce the value of their currency and increase net exports simultaneously.
What about the impact on inequality? As we did in the case of capital account liberalization in chapter 5, it is useful to look at a before-and-after plot of the data before proceeding to more formal tests. This is done in figure 6.2, which shows how the Gini coefficient was evolving, on average, before an episode of fiscal consolidation and how the path changed after consolidation. The path of the Gini coefficient clearly changes at the onset of austerity. Eight years after the start of an episode, the Gini coefficient is 1.5 percent points higher than its original value.
FIGURE 6.2: Inequality Before and After Fiscal Consolidation
Fiscal consolidation tends to have long-lasting negative impacts on income inequality.
Note: The y-axis shows the percentage point change in the Gini coefficient.
Source: Ball, Furceri, Leigh, and Loungani (2013).
This suggestive evidence is corroborated by formal econometric methods, the results of which are shown in figure 6.3. The figure shows the estimated effect of fiscal consolidation on the Gini coefficient and the associated confidence bands (dotted lines). It is evident that consolidation has a long-lasting effect on income inequality. In particular, the estimates suggest that consolidation episodes have increased the Gini index by about 0.1 percentage point (equivalent to about 0.4 percent) in the short term—one year after the occurrence of the consolidation episode—and by about 0.9 percentage point (equivalent to 3.4 percent) in the medium term—eight years after the occurrence of the consolidation episode.
FIGURE 6.3: Effect of Fiscal Consolidation on Inequality
Fiscal consolidations are associated with significant and persistent increases in income inequality.
Note: The dotted lines show one standard error band.
Source: Ball, Furceri, Leigh, and Loungani (2013).
Another way to assess the distributional effects of fiscal consolidation measures is to look at their effect on different types of income. As noted in chapter 2, a traditional way of splitting total income is into the share that goes to labor and the share that goes to capital in the form of profits, rents, and the like. This harks back to times when the roles of workers were fairly distinct from those of capitalists and landlords. While these distinctions have eroded somewhat over time, the split between wages and other forms of income “remains embedded in our national income accounts and in our politics” as a starting point for describing how income is divided between Main Street and Wall Street (Galbraith 2016).
The pain of consolidation is not borne equally. Fiscal consolidation reduces the slice of the pie going to wage earners. For every 1 percent of GDP of fiscal consolidation, inflation-adjusted wage income typically shrinks by 0.9 percent, while inflation-adjusted profit and rents fall by only 0.3 percent. Also, while the decline in wage income persists over time, the decline in profits and rents is short-lived (figure 6.4, top two panels). As a consequence, labor’s share of the income pie shrinks as a result of consolidation (figure 6.4, bottom panel).
FIGURE 6.4: Effect of Fiscal Consolidation on Labor’s Share of Income
Decline in wage income persists over time after fiscal consolidation whereas the decline in profits and rents is short. Therefore, labor’s share of the income shrinks as a result of consolidation.
Source: Ball, Furceri, Leigh, and Loungani (2013).
The reasons for wage income declining more than profits and rents have not yet been studied much. Some fiscal austerity plans call for public sector wage cuts, thus providing a direct channel for this effect. But there could be indirect channels as well, through the impact of consolidations on total unemployment and on the share of long-term unemployed in the total. Though the unemployed do receive unemployment benefits, their incomes nevertheless take a substantial hit and thus are an important source of the decline in overall wage income. The long-term unemployed, particularly, run out of benefits at some point and are thus likely to suffer sharp falls in income.
Indeed, the evidence shows that fiscal consolidations raise both short-term and long-term unemployment, as shown in figure 6.5, but the impact is much greater on the latter. Long-term unemployment refers to spells of unemployment lasting greater than six months. Moreover, within three years the rise in short-term unemployment due to fiscal consolidation comes to an end, but long-term unemployment remains higher even after five years.
FIGURE 6.5: Effect of Fiscal Consolidation on Short-Term and Long-Term Unemployment
Fiscal consolidations raise long-term unemployment (bottom) more than short-term unemployment (top).
Note: The dotted lines are one-standard-error bands.
Source: Ball, Leigh, and Loungani (2011).
Fiscal consolidations thus add to the pain of those who are likely to be already suffering the most—the long-term unemployed. This is a particular worry today because the share of long-term unemployed increased in most OECD countries during the Great Recession. And even in countries where it did not increase—such as Germany, France, Italy, and Japan—the share had already been very high even before the recession. Job loss is associated with persistent earnings loss, adverse impacts on health, and declines in the academic performance and earnings potential of the children of displaced workers (Dao and Loungani 2010). These adverse impacts are exacerbated the longer a person is unemployed. Moreover, long spells of unemployment reduce the odds of being rehired. For instance, in the United States, a person unemployed for over six months had only a 1 in 10 chance of being rehired in the next month, compared with 1 in 3 odds for a person unemployed less than one month. The increase in long-term unemployment thus carries the risk of entrenching unemployment as a structural problem because workers lose skills and become detached from the labor force—a phenomenon referred to as hysteresis.
Long-term unemployment also threatens social cohesion. An opinion survey conducted in sixty-nine countries around the world found that an experience with unemployment leads to more negative opinions about the effectiveness of democracy and increases the desire for a rogue leader. The effects were found to be more pronounced for the long-term unemployed.
This chapter has examined the distributional effects of fiscal austerity. Episodes of fiscal consolidation for a sample of seventeen OECD countries over the past three decades have typically led to a significant and persistent increase in inequality, declines in wage income and in the wage share of income, and increases in long-term unemployment. These results are not confined to advanced economies; subsequent work by other authors has shown that inequality in emerging markets and low-income economies also increases in the aftermath of fiscal consolidation (Woo et al. 2017). The research described here shows that it is important to have realistic expectations about the short-term consequences of fiscal consolidation: it is likely to lower incomes—hitting wage-earners more than others—and raise unemployment, particularly long-term unemployment. The notion that fiscal consolidations can be expansionary (i.e., raise output and employment), championed, among others, in the academic world by Harvard economist Alberto Alesina or in the policy world by former European Central Bank President Jean-Claude Trichet, has been seriously debunked. Instead, the short-run costs must be balanced against the potential longer-term benefits that consolidation can confer.
It is also important to be clear about the long-term benefits of paying down the debt when countries have fiscal space. There is little theoretical basis for setting a public debt target at some particular level (such as 60 percent of GDP under Maastricht or the 90 percent of GDP threshold discussed in Reinhart and Rogoff 2010). The seminal contributions from the economics literature point in all directions, from an ever-rising optimal level of public debt (if governments lack the ability to commit to future policies) to the accumulation of a large portfolio of assets (negative debt) to cope for adverse shocks under a precautionary saving motive. In its policy advice, the IMF has been more concerned with the pace of fiscal consolidation, ensuring that the pace is not too slow to give markets concern but not too fast to derail recovery. Hence, while the IMF has not questioned the need to bring down public debt ratios in the advanced countries from their high levels, it has not pushed for quick attainment of a particular public debt target.
