By Marie Schofield
November 27, 2012
Fiscal consolidations are underway across the developed world, and many require large adjustments. At a minimum, countries need to bring their primary budgets into balance in an effort to stabilize growing debt-to-gross domestic product (GDP) ratios. Many are looking at trimming deficits totaling 5% of GDP or more. This will require both spending cuts and tax increases which often work counter to stabilizing debt ratios, as this can brake GDP growth and undermine both the fiscal position and the political fortitude for action. It is a complicated balancing act. Act too slowly or too little and progress is stymied. Act too quickly or too much and the economy may flounder.
Fiscal belt tightening is painful and the adjustments can have potentially large impacts on growth, particularly in the short term. Just watch the news from any of the distressed countries in Europe. Fiscal multipliers describe the change in GDP that is due to changes in tax and spending policies. Multipliers work both ways—providing stimulus for growth or austerity from cutbacks. For instance a multiplier of 1.5x means that $1 in government spending cuts or higher taxes reduces GDP by $1.5, but a multiplier of 0.5x means a $1 cut reduces GDP by 50 cents. Many economists believed multipliers were between 0.5 and 1.0, but more recent studies from the International Monetary Fund (IMF) and others cast some doubt on this. Estimates of fiscal multipliers are now all over the map, but most believe fiscal multipliers are much higher due to a variety of factors, some internal and some external, based on country fundamentals and initial macro conditions. These include starting debt and growth levels, the size of the output gap, the magnitude of deficits, demographic changes and the availability of currency mechanisms, monetary policy and trade channel to balance or offsets some of the effects. What works in one country can prove counterproductive in another. A recent IMF study found multipliers have been in the 0.9x to 1.7x range in the recent experience in Europe.
First of all, most agree not all tax increases or spending cuts have the same multiplier—it matters what you tax and what you cut, and it matters whether they are temporary or permanent. It matters if there is a fixed exchange rate (so the impacts can’t be deflected) and if there is a synchronized fiscal adjustment occurring across numerous countries at once (which limits the ability of the trade channel to balance). Most of all it matters if monetary policy is constrained by the zero-bound. Indeed most feel effects are amplified (higher multipliers) if interest rates are already at zero. Adjustments, therefore, are more painful in closed economies (think Japan), those with fixed exchange rates (think Europe), those with large output gaps, and those countries where interest rates have already hit the zero bound (think U.S.). Also, stimulus spending is found to be less efficient in countries with massive debt.
As a result, most advocate a go-slow approach, pointing to a “speed-limit” for fiscal consolidation. This would be the amount of budget tightening that can both serve to stabilize debt-to-GDP ratios but also not undermine growth and the fiscal position itself. In the U.S. we are constrained by the zero-bound interest rate policy, which means monetary policy will have less of a cushion. Indeed, the Fed has made this clear in recent statements. The fiscal cliff represents about 5% of GDP. I believe potential GDP is between 2% and 3%, held back by the various headwinds still impacting growth. If we assume a multiplier for the U.S. of 1.0x to 1.5x, the U.S. could possibly handle a fiscal adjustment of 1% to 1.5% (or about $200 billion), but not much more. Lawmakers in Washington need to balance the pressing need to trim deficits against the inherent speed limits of budget cutting to avoid completely swamping growth.
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