Expansionary Fiscal Consolidation Myth

By Anis Chowdhury, former Professor of Economics, University of Western Sydney, who held various senior United Nations positions in New York and Bangkok and Jomo Kwame Sundaram, former UN Assistant Secretary General for Economic Development. Originally published at Inter Press Service

The debt crisis in Europe continues to drag on. Drastic measures to cut government debts and deficits, including by replacing democratically elected governments with ‘technocrats’, have only made things worse. The more recent drastic expenditure cuts in Europe to quickly reduce public finance deficits have not only adversely impacted the lives of millions as unemployment soared. The actions also seem to have killed the goose that lay the golden egg of economic growth, resulting in a ‘low growth’ debt trap.

Government debt in the Euro zone reached nearly 92 per cent of GDP at the end of 2014, the highest level since the single currency was introduced in 1999. It dropped marginally to 90.7 per cent at the end of 2015, but is still about 50 per cent higher than the maximum allowed level of 60 per cent set by the Stability and Growth Pact rules designed to make sure EU members “pursue sound public finances and coordinate their fiscal policies”. The debt-GDP ratio was 66 per cent in 2007 before the crisis.

High debt is, of course, of concern. But as the experiences of the Euro zone countries clearly demonstrate, countries cannot come out of debt through drastic cuts in spending, especially when the global economic growth remains tepid, and there is no scope for the rapid rise of export demand. Instead, drastic public expenditure cuts are jeopardizing growth, creating a vicious circle of low growth-high debt, as noted by the IMF in its October 2015 World Economic Outlook.

Deficits, Debt and Fiscal Consolidation

Using historical data, a number of cross-country studies claimed that fiscal consolidation promotes growth and generates employment. Three have been the most influential among policy makers dealing with the economic crisis unleashed by the 2008-2009 global financial meltdown.

First, using data from advanced and emerging economies for 1970-2007, the IMF’s May 2010 Fiscal Monitor claimed a negative relationship between initial government debt and subsequent per capita GDP growth as a stylized fact. On average, a 10 percentage point increase in the initial debt-GDP ratio was associated with a drop in annual real per capita GDP growth of around 0.2 percentage points per year. By implication, a reduction in debt-GDP ratio should enhance growth. Released just before the G20 Toronto Summit, it provided the ammunition for fiscal hawks urging immediate fiscal consolidation. The IMF has since admitted that its fiscal consolidation advice in 2010 was based on an ad-hoc exercise.

Using a different methodology, the IMF’s 2010 World Economic Outlook reported that reducing fiscal deficits by one per cent of GDP “typically reduces GDP by about 0.5% within two years and raises the unemployment rate by about 0.3 percentage point”. Domestic demand—consumption and investment—falls by about 1%”. Similarly, a 2015 IMF research paper concluded that “Empirical evidence suggests that the level at which the debt-to-GDP ratio starts to harm long-run growth is likely to vary with the level of economic development and to depend on other factors, such as the investor base”.

The second study, of 107 episodes of fiscal consolidation in all OECD countries during 1970-2007 by Alberto Alesina and Silvia Ardagna, found 26 cases (out of 107) of fiscal consolidation associated with resumed growth, probably influenced policy makers most. This happened despite the actual finding that “… sometimes, not always, some fiscal adjustments based upon spending cuts are not associated with economic downturns.”

Yet, in Harvard Professor Alesina’s public statement, “several” became “many” and “sometimes” became “frequently”, and mere “association” implied “causation”. In April 2010, Alesina told European Union economic and finance ministers that “large, credible and decisive” spending cuts to rescue budget deficits have frequently been followed by economic growth. Alesina was even cited in the official communiqué of an EU finance ministers’ meeting.

Jonathan Portes of the UK Treasury has acknowledged that Alesina was particularly influential when the UK Treasury argued in its 2010 ‘Emergency Budget’ that the wider effects of fiscal consolidation “will tend to boost demand growth, could improve the underlying performance of the economy and could even be sufficiently strong to outweigh the negative effects”. Christina Romer, then Chair of the US President’s Council of Economic Advisors, also acknowledged that the paper became ‘very influential’, noting exasperatedly that “everyone has been citing it”.

Researchers have found serious methodological and data errors in this work. Historical experience, including that of current Euro zone economies, suggests that the probability of successful fiscal consolidation is low. These successes depended on factors such as global business cycles, monetary policy, exchange rate policy and structural reforms.

Drawing on the IMF’s critique of Alesina and his associates, even the influential The Economist (30 September, 2010) dismissed the view that fiscal consolidation today would be “painless” as “wishful thinking”. Nevertheless, the IMF’s policy advice remained primarily in favour of fiscal consolidation regardless of a country’s economic circumstances or development level. There seems to be a clear disconnect between the IMF’s research and its operations.

The third study, by Harvard Professors Carmen Reinhart and Kenneth Rogoff on the history of financial crises and their aftermaths, claimed that rising government debt levels are associated with much weaker economic growth, indeed negative rates. According to them, once the debt-to-GDP exceeds the threshold ratio of 90 per cent, average growth dropped from around 3 per cent to -0.1 per cent in the post-World War II sample period. Since then, however, significant data omissions, questionable weighting methods and elementary coding errors in their original work have been uncovered. Nevertheless, the Reinhart-Rogoff findings were seized upon by the media and politicians around the world to justify austerity policies and drastic public spending cuts.

Bill Clinton, Fiscal Hawk?

Supporters of austerity based fiscal consolidation often cite President Bill Clinton’s second term in the late 1990s. However, the data shows that fiscal consolidation was achieved through growth, contrary to the claim that austerity produced growth. Clinton broke with the traditional policy of using the exchange rate to address current account or trade imbalances, opting for a strong dollar. Thus, the US dollar rose against major currencies from less than 80 in January 1995 to over 100 by January 2000.

The strong US dollar lowered imported inflation, allowing the Fed to maintain low interest rates even though unemployment fell markedly. The low interest rate policy not only boosted growth, but also helped keep bond yields close to nominal GDP growth rates. Thus, the interest burden was kept under control, with primary balances stable at close to zero.

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  1. tegnost

    Were I to off handedly choose the “looting years”, i also would go with 1970-2007. Union busting could be considered by the upper crust to be a successful austerity policy, as was the mentioned strong dollar policy, which pitted workers against weaker currencies creating comparative advantage. By 2010 clearly the cat was out of the bag that it was/is a big shell game (re:even the influential The Economist (30 September, 2010)), but rather than three shells we have many more facets to choose from and under which viable data is hidden…
    “The strong US dollar lowered imported inflation, allowing the Fed to maintain low interest rates even though unemployment fell markedly. The low interest rate policy not only boosted growth, but also helped keep bond yields close to nominal GDP growth rates. Thus, the interest burden was kept under control, with primary balances stable at close to zero.”
    I count six shells in this passage alone…
    so much for simple answers to complicated problems.

    1. Paul Greenwood

      I would agree with the thrust of your post. It is bizarre that in viewing the wreckage of a drug-induced euphoria coupled with spending spree the perpetrators think all that is needed is to sweep the rubble into neat piles and everything will be fine.

      The Western Model collapsed in 1973 once it lost cheap oil and was buried in 1978 when Iran re-priced oil. Credit Expansion was possible in oil-producing states and essentially overvalued currencies gave mercantilist exporters the ability to thrive. This “Dutch Disease” situation was reinforced through petrodollar recycling through London and NYC boosting FIRE sector incomes and skewing income distribution.

      Christopher Lasch had a great book “Revolt of the Elites” and it was this that facilitated societal restructuring via the external sector as a policy objective of the ruling elites. It was to use the 19th Century approach used in Britain whereby production was shifted to cheap German suppliers until Germany became a serious industrial rival and expansionist power.

      The use of cheap energy inputs and then easy credit policies kept the Western Model afloat but ultimately led to its demise and internal decomposition as it became ever-more reliant on Central Planning through Credit/Bond Markets piling up liabilities which would/could never be honoured.

  2. Robert Hahl

    To sum up,

    austerity = wage suppression, which leads to debt trap.

    Perhaps payday loans would help?

  3. MikeNY

    Supporters of austerity based fiscal consolidation often cite President Bill Clinton’s second term in the late 1990s. However, the data shows that fiscal consolidation was achieved through growth

    Clinton’s second term also coincided with a Brobdingnagian equity bubble. How much of that ‘growth’ was attributable to Alan Greenspan’s blossoming boobery?

  4. ray phenicie

    The strong US dollar lowered imported inflation, allowing the Fed to maintain low interest rates even though unemployment fell markedly. The low interest rate policy not only boosted growth, but also helped keep bond yields close to nominal GDP growth rates. Thus, the interest burden was kept under control, with primary balances stable at close to zero.

    I’m not certain I accept all that. More important, in my estimation, is that during the so called Goldilock years (1993 to around 2001), the government ran budget surpluses while the private sector began its long trek down homeowner debt row. Renegade Banks mailed out pre-approved credit cards by the basketful, car dealers opened up spigots of money, and mortgage fraud found a new home in Wall Street. In short, the private sector more than made up for money that was not being transferred to it by spending savings and going into bank financed debt. All of the spending (mostly borrowed money) had the effect of keeping up employment.

    (we call it deficit spending on the part of the government but in reality the government is transferring money to the private sector all the time. The real kicker is that people like Paul Ryan pretend to be concerned about all this but I see the real problem as a philosophy that says “the government can’t ‘help’ the private sector.” That is a completely different take on the whole phenomena).

    Came the time to pay the catering company after the party was over and lo and behold (wonder of wonders) and households went into bankruptcy and repo land in huge numbers. It was a migration of epic proportions by 2006. The adequate history of this time has yet to be written.

    1. ray phenicie

      I should have made the point that interest rates and the relative value of the U. S. dollar weren’t really the motivating forces here. What was the motivating force behind the creation of a huge asset bubble was simply the philosophy of bankers (abetted by government non regulation): “We’ll go out and gut the private sector and rake in as much ‘profit’ as is possible by any means possible.”

      1. Paul Greenwood

        Started with “Bridge-Financing” with Wasserella putting the balance sheet of CSFB on the block and calling it “Merchant Banking” then with Sumitomo buying a stake in Goldman – it showed the risk profile was so extreme that serious equity was being risked by “Advisers” in the hope of gambling returns

  5. Sound of the Suburbs

    Lawrence Summers’ secular stagnation = Richard Koo’s balance sheet recession

    The majority are loaded up with debt and making the repayments on mortgages, payday loans, sub-prime auto-loans, student loans and personal loans.

    The economy is just about breaking even as the money supply undergoes its natural contraction when repayments are an amount larger than the new debt coming into existence.

    Bill Clinton ushered in the age of finance and deregulated the industry allowing almost unlimited credit to enter the economy.

    Bankers’ did not lend this money productively into business and industry but concentrated on mortgages, payday loans, sub-prime auto-loans, student loans and personal loans.

    The consumer became loaned up, with little purchasing power to consume anything in the wider economy.

    No one seems to understand it apart from Richard Koo and the people who have read his book at the FED.

    In Europe the policy makers impose austerity, not realising it is the worst thing they could do when the money supply is contacting.

    European policy makers, including those in the UK, it’s time to spend the most productive one and a half hours you’ve had in the last eight years:


    Fiscal policy is what you need with all this unproductive lending weighing everything down.

    This is what Japan learnt from 25 years of experience.

    In another of Richard Koo’s videos he tells how Western experts came along and told Japan to cut Government spending and every time things got worse until they increased Government spending again.

    It was long, hard, painful experience.

    Japan was recovering when 2008 hit.

    Japan was getting better again and the Tsunami hit.

    The current Governor of the BoJ seems to have appeared out of nowhere and is doing all the wrong things (reading between the lines of Richard Koo’s account).

    Richard Koo was more of an observer and could not over-ride the Western experts and their bad advice.

    1. Sound of the Suburbs

      The hidden knowledge, the very nature of money itself, this is why everyone keeps coming to the wrong conclusions.

      We don’t really seem to be getting anywhere after 2008.

      Neoclassical economics was rolled out across the world for the globalisation project.

      The most fundamental of all fundamentals is flawed in this economics, the very nature of money itself.

      It assumes the money supply is constant and one person’s debt is an amount lent by someone else.

      These flawed assumptions have created the mess we are in today and leads people to believe that lending of any type causes no problems.

      The reality.

      Money and debt are opposite sides of the same coin.
      If there is no debt there is no money.
      Money is created by loans and destroyed by repayments of those loans.

      Banks were deregulated and reserve requirements were set very low to allow almost infinite credit to enter the system.

      Before 2008, tons of new debt was coming into existence and the money supply increased and fed into the general economy. It felt like there was lots of money about because there was.

      All this new money didn’t impact inflation figures that much because most of the inflation was taking place in real estate that isn’t included in the inflation figures.

      After 2008, hardly anyone is taking on new debt and everyone is making repayments, the money supply shrinks and gets sucked out of the general economy. It feels like there isn’t much money about because there isn’t.

      Your intuition is more accurate than the neoclassical economist who assumes the money supply is constant.

      In the balance sheet recession, when the private sector isn’t borrowing, there is little new debt and lots of repayments causing the money supply to contract.

      Government borrowing is the only way to stop the money supply contracting.

      QE doesn’t work because the money goes to the banks but does not enter the general economy as no one is borrowing. This is why QE hasn’t caused inflation, the money has just gone into bank reserves and hasn’t entered the general economy.

      When the money supply is contracting the worst thing you can do is austerity as Greece and the Club-Med nations demonstrate. As things get worse, loans default and their banks start to collapse.

      We just don’t understand money, the most fundamental of all fundamentals in a Capitalist system.

      “Where does money come from?” available from Amazon.

      Step out of the dark and into the light.

      Or the BoE if you prefer:



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