Fiscal Adjustment: Too Much of a Good Thing?

By Carlo Cottarelli

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The IMF has argued for some time that the very high public debt ratios in many advanced economies should be brought down to safer levels through a gradual and steady process. Doing either too little or too much both involve risks: not enough fiscal adjustment could lead to a loss of market confidence and a fiscal crisis, potentially killing growth; but too much adjustment will hurt growth directly.

At times over the last couple of years we called on countries to step up the pace of adjustment when we thought they were moving too slowly.

Instead, in the current environment, I worry that some might be going too fast.

Risk to recovery

The latest update of the Fiscal Monitor shows that fiscal adjustment is proceeding pretty quickly in the advanced economies—on average the deficit is projected to fall by a total of 2 percentage points of GDP in 2011-12. The decline is even larger in the euro area—about 3 percentage points of GDP. In a reasonably good growth environment this pace of adjustment would be fine. But in the current weaker macroeconomic environment bringing deficits down this quickly could pose a risk for the economic recovery.

Some might argue that adjusting is like taking a bitter medicine, and that it's always best to get it over with as quickly as possible. Aggressive fiscal adjustment will surely be rewarded by markets through lower interest rates, and any cost to growth is simply the price paid to ensure that fiscal credibility is won or maintained.

Fiscal austerity & market behavior

But market behavior is much more complex than this, at least in the current crisis. For sure, markets don’t like large debt and fiscal deficits, but they also don’t like low growth. Take the recent downgrades of several European countries. Were they purely the result of fiscal problems? No. Look at the words used by Standard and Poor’s: “a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.”

Some of our analytical work at the IMF makes this point clearly. It shows that lower debt ratios and deficits lead to lower interest rates on government bonds, but so too does faster short-term growth. So, when countries tighten fiscal policy and the economy slows, some of the gains from better fiscal fundamentals will be lost through lower growth. We also see some evidence of a nonlinear relationship between growth and sovereign bond spreads: spreads are more likely to increase when growth is already lower and the fiscal tightening is larger (see chart). If growth falls enough as a result of a fiscal tightening, interest rates could actually rise as the deficit falls.

Country-specific fiscal policy

So how should fiscal policy respond if growth slows more than expected?

For some advanced economies, limited access to financing leaves them no option but to stick to their deficit reduction plans this year. But fiscal tightening cannot be the only tool to restore market confidence. Structural reforms to boost competitiveness and growth are also critical, but even reforms started today will take time to yield results. So it will be critical to support countries that are adjusting at an appropriate pace by making adequate financing available to them—in the euro area, through the European Financial Stability Facility and the European Stability Mechanism—to provide a boost to confidence while market perceptions adjust. Markets eventually respond to improved economic fundamentals like stronger medium-term growth and lower future deficits, but on occasion this takes a while.

There are many other advanced economies, however, where fiscal policy has more freedom. If growth slows, these countries should avoid further fiscal tightening. They should allow the impact of an economic downturn on revenues and spending on things like unemployment benefits to raise the deficit temporarily.

Among those countries with more flexibility, there are some—including in the euro area—where very low interest rates or other factors are creating adequate fiscal space to allow them to reconsider the pace of deficit reduction this year.

Take for example the United States. Based on current policies, the deficit would decline by over two percentage points of GDP in 2012, the largest single year adjustment in four decades. That’s too much. Renewing the payroll tax cut and extending unemployment compensation for the long-term unemployed—two measures set to expire this year—would provide welcome support to the economy. Actions like these would be greatly facilitated by the adoption of credible medium-term adjustment plans, which are still missing in some key economies.

The bottom line

Government debt remains very high in many advanced economies, and fiscal adjustment to bring debt down over the medium term is essential. Nearly all advanced economies plan to reduce their deficits this year. But if growth slows more than expected, some may feel inclined to preserve their short-term plans through additional tightening, even if hurts growth more. My bottom line for them: unless you have to, you shouldn’t.

2017-04-15T14:13:28+00:00January 29, 2012|


  1. Per Kurowski January 29, 2012 at 9:41 pm

    Very high public debt ratios were facilitated, or even promoted by regulations which allow banks to have little or no capital when lending to sovereigns, while their credit ratings deem these as infallible.

    But now when many safe havens have become dangerously overcrowded, that mechanism goes into reverse and so, to the contraction produced by the necessary fiscal adjustment we are also adding the contraction produced by the bank system’s deleveraging. And we can’t afford that double whammy.

    Let’s face it, if we accept that a lot of bad businesses was placed on the books of the banks because of these regulations, there is little to be gained hurrying retroactively too much to make up for the mistakes.

    In this respect one proposal I have made is declaring a ten year new capital requirement moratorium on all current bank exposures; allowing the banks to run any new lending with whatever new capital they can raise, while imposing an equal 8 percent capital requirement on any new bank business, meaning no risk-weighting. If there’s an exception, that should be on the lending to small businesses and entrepreneurs, in which case one could require the banks to hold for instance only 6 percent of capital, because these borrowers do not pose any systemic risk, and also because, when the going gets to be risky, all of us risk-adverse, really need the “risky” risk-takers to get going.

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  3. George Naumovski January 29, 2012 at 10:52 pm

    Excellent article and insight. I agree about doing too little or too much with not enough fiscal adjustment will kill growth and the chance for nations to pay back debt!

    If governments keep bailing out corporations/banks and still give out tax cuts to the business elites, well then the debt/crisis will never end.

    How much austerity can nations have until the majority are at the breaking point?

  4. Angus Cunningham January 30, 2012 at 12:47 am

    The chart supplied in Mr. Cottarelli’s post tells us that the relationship between rate of deficit reduction and rate of GDP growth varies much between different countries. It therefore supports the point that fast deficit reduction, almost always advocated by monetarist aficionados, is not always good even from the point of view of market participants.

    What seems to me to be missing from this analysis is consideration of how the profitability of the large cap corporate sector, which now has a huge pile of ‘defensive’ liquidity, is to be interested in assisting with the adjustments needed to transition economies around the world to more socially and environmentally sustainable paths.

    IMO, the investment strategists who advocate to their clients that such huge piles of cash should be held by large cap and/or state enterprises, are ignoring doing the explorative thinking necessary to stimulate venture capital flows into both the social and environmental innovations that the world as a whole desperately needs. Specific advice on such courses of action may be felt by top IMF leadership to be outside the mandate of the IMF from its government clients and shareholders, but, if so, should that deter IMF counsellors from pointing out the necessity for that thinking focus to be emphasized by their government clients?

  5. Angus Cunningham January 30, 2012 at 12:40 pm

    This point about the absurdities of the Basel Committe’s risk-weighting framework is a very crucial one. The incentives created by that risk-weighting capital requirements framework for bankers to lend to financially weak sovereigns and export their risk to other financial institutions, such as AIG, was enormous. Furthermore it was scandalous in several respects:

    o First, that experienced banking professionals in Basel should not have recognized the dangerously destabilizing reality they were promulgating,
    o Second, that the conflict of interest of bankers had in selling the complex derivatives by which they exported their risks was neither acknowledged by bankers nor addressed firmly by national regulators
    o Third, that top bank executives should have been so slow in adjusting their bonus compensation plans so as to rein in their derivative trader exploitation of it.

    That the IMF has not, so far, been vocal about publicizing these abuses of public trust does no credit to it as an institution to be trusted by the governments of those countries who were diligent in preventing the abuses in so far as they, in a globalized financial world, had the jurisdictional power.

    The positive side of this scandal for the IMF is that the opportunity for its leadership and counsellors to address, urgently and with integrity, this shortcoming in its institutional image remains.

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  7. Javed Mir January 31, 2012 at 7:20 pm

    Well explained and defended by Carol Cottarelli. Succinctly speaking, there is no harm in loadshedding of extra weight (of debts and deficits) by having regular and tough exercises, in order to protect the heart. Regular tread mill tests should be prescribed.

    The Ten commandments enunciated by M/s Olivier Blanchard and Carol Cottarelli (dated 24.6.2010) (specifically Commandment VIII – strengthen your fiscal institutions), need to be followed with religious zeal.

  8. g.srinivasan, new delhi. February 1, 2012 at 8:07 am

    well, it is ironic that the Fund, which was known for its fiscal fetishism of the 1970s to mid-1990s when it subjected every borrower regardless of its status as a low-income or middle-income country ,is now singing the praise of preserving growth impulses for countries as they cut fiscal flab. Prudence dictates that a policy tailored to maintain public debt to a sustainable level cannot and will not succeed if in the process the country is unable to keep the credit sluice ajar for productive segments/agents of the economy. That is why the monetary tightening in the face of inflation or high inflation expectations in emerging economies like India has always been frowned upon by trade/industry, farmers and the services segment. It is time that multilateral development agencies, with their econometrics-economists, get their feet planted firmly on the ground and prescribe policies that suit individual country’s ability and capacity to maintain growth momentum instead of suggesting to them one-size fits all approach that would only bring reproach from all those who have been affected overtly or covertly.

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  10. Jason Mutch February 2, 2012 at 1:40 pm

    A point of clarification, in countries with sovereign fiat currency (US, Canada, UK, etc.) markets do not (nor can they ever) set interest rates on bonds, central banks do. Perhaps this is why your interest rate charts show an unreliable correlation between fiscal actions and bond rates, because it’s not a correlation whatsoever especially if you bundle countries with sovereign currencies and non-sovereign EU countries. It might be an interesting exercise to produce separate charts for UE countries using the Euro versus countries with free floating fiat currencies.
    Jason Mutch, Ottawa Canada

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