The Debate on Expansionary Fiscal Consolidation: How Robust is the Evidence?

Abstract

This paper critically examines the key empirical evidence used to support the fiscal consolidation argument, complemented by a brief assessment of the limitations of the analytical foundation of the growth promoting benefits of the fiscal consolidation thesis. It also reviews the evidence on the debt-growth relationship at some length. It finds that the negative relationship between debt and GDP growth is influenced by outliers or exceptionally high debt-GDP ratios. It also points out that the composition of public debt matters. Additionally the debt-GDP relationship appears to be non-linear—positive first and turning to negative, but there is considerable variation in the estimated turning or ‘tipping’ point, which is not helpful as a policy guide. Historical evidence does not lend support to the concerns that the current situation is likely to cause rapid upward spiraling of public indebtedness. Finally, the argument that fiscal consolidation is possible without adversely affecting growth is not based on robust empirical evidence. This conclusion is reinforced by a succinct overview of some country-specific experiences (Denmark, Ireland and United States).

Get full access to this article

View all access options for this article.

References

Aizenman

Marion

(2009) ‘Using inflation to erode the U.S. public debt’ NBER Working Paper, No. 15562, National Bureau of Economic Research, Cambridge, MA.

Alesina

(2010) Fiscal adjustments: Lessons from history, Harvard University. Prepared for the Ecofin Meeting, Madrid, 15 April, available: http://www.economics.harvard.edu/faculty/alesina/files/Fiscal%2BAdjustments_lessons.pdf [accessed 20 July 2010].

Alesina

Ardagna

(2010) ‘Large changes in fiscal policy: taxes vs spending’ in Brown

Jeffrey R.

(ed.) Tax Policy and the Economy, 24, National Bureau of Economic Research, Cambridge, MA.

Alesina

Perotti

Giavazzi

Kollintza

(1995): ‘Fiscal expansions and adjustments in OECD economies’, Economic Policy, 21, pp. 205–248.

Berglund

Vernengo

(2004) A debate on the deficit’, Challenge, 47(6), pp. 5–54.

Blanchard

Dell'Ariccia

Mauro

(2010) ‘Rethinking macroeconomic policy’, IMF Staff Position Note, February, SPN/10/03.

Broyer

Brunner

(2010) From economic stimulus packages to fiscal consolidation: what net effect on growth?, June 4, NATIXIS Brief No. 283.

Bruno

Easterly

(1998) ‘Inflation crises and long-run growth’, Journal of Monetary Economics, 41(1), pp. 3–26.

Caner

Grennes

Koehler-Geib

(2010) Finding the tipping point—when sovereign debt turns bad, World Bank Policy Research Working Paper 5391.

10.

Cecchetti

Mohanty

Zampolli

(2010) ‘The future of public debt: Prospects and implications’, BIS Working Paper No. 300.

11.

Chick

Pettifo

(2011) The economic consequences of Mr. Osborne: Fiscal consolidation: Lessons from a century of UK macroeconomic statistics, available: http://www.primeeconomics.org/wp-content/uploads/2011/06/The_Economic_Consequences_of_Mr_Osborne.pdf [accessed 20 August 2012].

12.

Chowdhury

Islam

(2010a) The fallacy of austerity-based fiscal consolidation, A commentary in the VoxEU Debate ‘Development and the crisis’, 19 July, available: http://www.voxeu.org/index.php?q=node/5312 [accessed 12 August 2012].

13.

Chowdhury

Islam

(2010b) Is there an optimal debt-to-GDP ratio?' A commentary in the VoxEU Debate Development and the crisis, available: http://www.voxeu.org/index.php?q=node/5764 [accessed 12 August 2012].

14.

Cordella

Ricci

Ruiz-Arranz

(2005) ‘Debt overhang or debt irrelevance? Revisiting the debt-growth link, IMF Working Papers, WP/05/223, available: http://www.imf.org/external/pubs/ft/wp/2005/wp05223.pdf [accessed 20 September 2012].

15.

Cordella

Ricci

L. A.

Ruiz-Arranz

(2010) ‘Debt overhang or debt irrelevance? Revisiting the debt-growth link, IMF Staff Paper, 57(1), pp. 1–24.

16.

Cottarelli

Jaramillo

(2012) ‘Walking hand in hand: Fiscal policy and growth in advanced economies’, IMF WorkingPaper 12/137.

17.

De Grauwe

(2011) The governance of a fragile Eurozone, Proceedings, University of Leuven and Centre for European Policy Studies (CEPS), Brussels.

18.

DeLong

J. B.

Eichengreen

(2001) Between meltdown and moral hazard: the international monetary and financial policies of the Clinton Administration, Paper presented at the Conference on the Economic Policies of the Clinton Administration, Kennedy School of Government, 26–29 June.

19.

Dermott

C. J.

Wescott

(1996) ‘Fiscal reforms that work’ Economic Issues, No.4, IMF, available: http://www.imf.org/external/pubs/ft/issues4/index.htm [accessed 23 August 2012].

20.

Development Committee (2006) Fiscal Policy for Growth and Development: An Interim Report, prepared by Poverty Reduction and Economic Management, World Bank.

21.

Domar

(1944) ‘The “burden of the debt” and the national income’, American Economic Review, 34(4), pp. 798–827.

22.

Domar

(1993) ‘On deficits and debt’, American Journal of Economics and Sociology, 52(4), pp. 475–478.

23.

ECB (European Central Bank) (2003) Monthly Bulletin, November, available: http://www.ecb.int/pub/pdf/mobu/mb200311en.pdf [accessed 23 August 2012].

24.

ECB (2010) Interview with Libération. Interview with Jean-Claude Trichet, President of the ECB, and Libération, conducted by Jean Quatremer, 8 July, available: http://www.ecb.int/press/key/date/2010/html/sp100713.en.html [accessed 25 August 2012].

25.

Fatás

(2010) The economics of achieving fiscal sustainability, paper presented to Board of Governors, Federal Reserve, April 9.

26.

Federal Ministry of Finance, Germany (2010) German Stability Programme January 2010 Update.

27.

Giavazzi

Pagano

(1990) ‘Can severe fiscal contractions be expansionary? Tales of two small European countries’ in Blanchard

Fischer

(eds) NBER Macroeconomics Annual 1999, MIT Press, Cambridge, MA.

28.

Godley

Izurieta

(2003) Coasting on the lending bubble: Both in the U.K. and in the U.S., Paper presented at the Annual Meeting of the Society of Business Economists, London, June 25.

29.

Godley

Martin

(1999) ‘How negative can U.S. saving get?’ Policy Note 1999/1, the Levy Economics Institute, New York.

30.

Godley

Wray

(1999) ‘Can Goldilocks survive?’, Policy Note, 1999/4, The Levy Economics Institute, New York.

31.

Godley

(2003) ‘The U.S. economy: A changing strategic predicament’, Strategic Analysis, Levy Economics Institute, New York.

32.

Hart

(2011) ‘Macroeconomic policy and Abba Lerner's system of functional finance’, Economic Papers, 30(2), pp. 208–217.

33.

Hemming

Kell

Mahfouz

(2002) The effectiveness of fiscal policy in stimulating economic activity—a review of the literature, IMF Working Paper, WP/02/2002.

34.

IMF (International Monetary Fund) (1996) World Economic Outlook: Fiscal Challenges facing Industrial Countries, May, IMF, Washington DC.

35.

IMF (2002) ‘Assessing sustainability’, Paper prepared for the Policy Development and Review Department, 28 May, IMF, Washington D.C.

36.

IMF (2010a) World Economic Outlook: Rebalancing Growth, April, IMF.

37.

IMF (2010b) ‘From stimulus to consolidation: Revenue and expenditure policies in advanced and emerging economies’, IMF Policy Paper, 30 April, IMF.

38.

IMF (2010c) Fiscal Monitor: Navigating the Fiscal Challenges Ahead, 14 May, IMF.

39.

Islam

Chowdhury

(2010a) Fiscal consolidation, growth and employment: What do we know? A commentary in the VoxEU Debate Development and the crisis, 21 June, available: http://www.voxeu.org/index.php?q=node/5216 [accessed 12 August 2012].

40.

Islam

Chowdhury

(2010b) Fiscal consolidation, growth and employment: What do we know? G-24 Policy Brief No. 57, 3 August, available: http://www.g24.org/PolicyBriefs/pbno57.pdf [accessed 12 August 2012].

41.

Islam

Chowdhury

(2010c) The fallacy of austerity-based fiscal consolidation, G-24 Policy Brief No. 58, 15 August, available: http://www.g24.org/PolicyBriefs/pbno58.pdf [accessed 12 August 2012].

42.

Islam

Hengge

(2012) ‘Fiscal austerity, borrowing costs and the eurozone Economies’, Social Europe Journal, July 7, available: http://www.social-europe.eu/2012/07/fiscal-austerity-borrowing-costs-and-the-eurozone-economies/ [accessed 19 August 2012].

43.

Krugman

(2002) The Return of Depression Economics, Penguin Books, New York.

44.

Krugman

(2012) ‘Cameron and the confidence fairy: An update, The conscience of a Liberal’, New York Times blog, 11 February.

45.

Kirsaniova

Leith

Wren-Lewis

(2009) ‘Monetary and fiscal policy interaction in the light of recent developments’, The Economic Journal, 119(541), pp. F482–F496.

46.

Kumar

M. S.

Woo

(2010) Public debt and growth, IMF Working Paper, WP/10/174.

47.

Kyrili

Martin

(2010) The impact of the global economic crisis on the budgets of low-income countries, OXFAM Research Paper, July, available: http://www.oxfam.de/sites/www.oxfam.de/files/the_impact_of_the_economic_crisis_on_the_budget_of_low-income_countries.pdf [accessed 12 August 2012].

48.

Lerner

(1943) ‘Functional finance and the federal debt’, Social Research, 10(1), pp. 38–57.

49.

Manpower (2012) Manpower Employment Outlook Survey Global: Q3/2012, Manpower Group.

50.

Matthews

R. C. O.

(1968) ‘Why has Britain had full employment since the War?’, Economic Journal, 78(311), pp. 555–569.

51.

Missale

Blanchard

(1994) ‘The debt burden and debt maturity’, American Economic Review, 84(1), pp. 309–319.

52.

Murphy

A. E.

(2000) ‘The Celtic tiger — an analysis of Ireland's growth performance’ European University Institute Working Paper, RSC No 2000/16.

53.

Nevile

Kriesler

(2011) ‘Why Keynesian policy was more successful in the fifties and sixties’, The Economic and Labour Relations Review, 22(1), pp. 1–16.

54.

OECD (Organisation for Economic Cooperation and Development) (2009) OECD Observer, 270/271, December 2008–January 2009.

55.

OECD (2010) OECD Economic Outlook, 2010/2, OECD Publishing, available: http://dx.doi.org/10.1787/eco_outlook-v2010-2-en [accessed 20 August 2012].

56.

Ostry

J. D.

Ghosh

A. R.

Kim

J. I.

Qureshi

M. S.

(2010) Fiscal space, IMF Staff Position Paper, SPN/10/11, lSeptember.

57.

Perroti

(2011) The ‘austerity myth’: Gain without pain?, Paper produced as part of the project ‘Growth and Sustainability Policies for Europe’ (GRASP), funded by the European Commission's Seventh Research Framework Programme, contract number 244725.

58.

Portes

(2012) What does ‘Keynesian’ mean?, Not the Treasury View Blog, 27 January, available: http://notthetreasuryview.blogspot.com/ [accessed 22 August 2012].

59.

Posen

(2005) Don't kid yourself about fiscal consolidation, 6 November, Peterson Institute for International Economics.

60.

Pozen

(2010) ‘The US public debt hits its tipping point’, The Boston Globe, 23 February.

61.

Presbitero

A. F.

(2010) Total public debt and growth in developing countries, 12 November, available: http://www.csae.ox.ac.uk/conferences/2011-EDiA/papers/608-Presbitero.pdf [accessed 12 September 2012].

62.

Quiggin

(2011) Expansionary austerity: Some shoddy scholarship, available: http://johnquiggin.com/2011/10/25/expansionary-austerity-some-shoddy-scholarship/ [accessed 23 August 2012].

63.

Reinhart

Rogoff

(2010) ‘Growth in a time of debt’, American Economic Review, 100(2), pp. 573–577.

64.

Romer

(2000) ‘Keynesian macroeconomics without the LM curve’, Journal of Economic Perspectives, 14(2), pp. 149–169.

65.

The Economist (2010a) ‘Fiscal tightening and growth: A good squeeze — Bigger budgetary adjustments are not always better’, 31 March, Washington DC, available: http://www.economist.com/node/15819148 [accessed 20 August 2012].

66.

The Economist (2010b) ‘Economics focus: Does fiscal austerity boost short-term growth’, 30 September.

67.

UN (United Nations) (2011) World Economic Situation and Prospects 2011, United Nations, New York.

68.

UNICEF (United Nations Children's Fund) (2010) ‘Prioritizing expenditures for a recovery with a human face: Results from a rapid desk review of 86 recent IMF country reports’, Social and Economic Policy Working Briefs, April, available: http://www.escr-net.org/sites/default/files/Prioritizing_Expenditures.pdf [accessed 20 August 2012].

69.

Wren-Lewis

(2011) ‘Lessons from failure: fiscal policy, indulgence and ideology’, National Institute Economic Review, 217, July, pp. R1–R16.