Fiscal Austerity: Sometimes, It Doesn’t Make Sense

Among multilateral economic institutions, the United Nations Conference on Trade and Development or UNCTAD, has always been a bit of a maverick. They’ve been at best lukewarm supporters of the Washington Consensus, and more frequently critics of the policies of the IMF and the World Bank. Possibly it’s because they’re actually based in New York and Geneva instead of the hothouse atmosphere of Washington DC. More probably, it’s because UNCTAD has always been less snobbish about taking into its ranks economists from developing countries, and thus more sympathetic to the challenges facing developing nations.

In any case, even in these times, they’ve taken a markedly different view of what to do about the European debt crisis (from the summary):

On the Brink: Fiscal Austerity Threatens a Global Recession [warning: pdf link]

Due to sluggish private demand, several advanced economies are hovering on the brink of a second bout of recession. Yet, in many of these countries political attention has turned to ways to cut fiscal deficits and reduce the domestic public debt. This has created a dangerous accumulation of risks for the world economy. The private sector can only successfully deleverage (i.e., reduce its debt) if someone else is willing to take on higher debt and support demand. If the private and the public sectors try to deleverage simultaneously, they must either find debtors elsewhere, or the economy will tailspin into a depression. As the developing world is both unable and unwilling to accept the role of debtor of last resort, dangerous pressures are building up. Unless there is a rapid policy turnaround, the world is in danger of repeating the mistakes of the 1930s. In today’s highly integrated global economy, the contractionary contagion will affect all countries. Emerging and developing economies need to prepare contingency plans.

UNCTAD are channeling their inner Keynesian here – compare this analysis with the “creditors-must-be-paid” approach of the IMF and their preoccupation with debt sustainability and fiscal space. Even with haircuts in place, the IMF approach is still that of looking at Europe’s debt problems from the perspective of the creditors, and ignoring the very real human suffering (and growth hobbling) engendered by cutbacks in government spending.

UNCTAD doesn’t pull its punches either (emphasis added):

The Trade and Development Report (2011) reviews scores of cases where fiscal tightening did not trigger the sought after macroeconomic expansion but, rather, had the opposite effect. These include a long list of developing countries, whose damaging experiences in the last three decades ought to encourage current policymakers to do better. Chart 1 (A and B), below, summarises the experiences of countries receiving emergency IMF support during the financial crises of the late 1990s and early 2000s and also during the present crisis. Chart 1.A contrasts the forecasted impact on GDP growth of contractionary policies in these economies (in the horizontal axis), as expected in the Letters of Intent signed between the IMF and national governments, with their outcomes (in the vertical axis). Scatterpoints along the 45 degree line indicate cases where the expectations had proven to be correct. Points above that line indicate countries where the outcomes exceeded expectations, and points below the 45 degree line are countries where expectations were not achieved. It is evident on inspection that in virtually all countries the policy outcomes have systematically and unambiguously not met expectations. In some cases the gaps are substantial: in 1998, a GDP growth forecast of 5 per cent for Indonesia actually came in at minus 13 per cent, while Thailand was expected to achieve 3.5 per cent growth but actually contracted by 10.5 per cent. Similarly, in 2009, Latvia and Ukraine experienced a staggering fall in GDP that was three times as large as that anticipated.

…and…

When GDP growth falters, tax revenues are also likely to fall below expectations. At the same time, public expenditures are bound to overshoot because of the higher than expected benefits and social security payments and other transfers which must be made when the economy slows down. The passive but strongly positive role of these automatic stabilisers has been widely understood since the 1930s. It was also widely known that it is counterproductive to raise taxes or cut public spending during a recession because a fiscal contraction can unleash a vicious circle of economic decline. The adverse impact of many recent policy experiences could have been anticipated, in the light of economic theory and the experiences of dozens of developing countries since the early 1980s. Most tellingly, a detailed examination of the impact of fiscal adjustment in 133 IMF supported programmes in 70 countries, carried out by the IMF’s own Independent Evaluation Office (IEO) noted “a tendency to adopt fiscal targets based on overoptimistic assumptions about the pace of economic recovery leading inevitably to fiscal underperformance” and “overoptimistic assumptions about the pace of revival of private investment.” (IMF, 2003: vii). The lesson that fiscal tightening systematically fails to deliver fiscal consolidation is important for countries in the current crisis, and for those that are reeling under the pressure of declining growth forecasts.

Is any of this relevant to Malaysia? UNCTAD has a menu of policy options, but I think what’s particularly relevant to us is this one:

Countries should see fiscal policies as tools for growth and development, instead of automatically adopting a fiscal-phobic approach. Instead of asking whether their fiscal deficit is “too big”, they sould consider whether it is being used in the best way to stimulate the economy…Most importantly, however, in terms of global economic revival is the fact that, given the current lack of investor and household confidence, governments must play the role of “growth engine of last resort”. Income can be generated only if somebody spends, and experience suggests that, in a recession, the only “someone” available is often the government.

The lesson here: it’s not the debt, or the debt level, but rather the composition of government spending that really matters. Some may say this is all the same – that our debt level is due to wastage, inefficiency and corruption. But that misses the nuance of UNCTAD’s argument, which I fully agree with – whether government spending is wasteful or not, is a completely separate issue from its level.

The paradox is that increasing government efficiency, eliminating wastage and corruption, and generally reducing government spending could result in an economy that’s growing slower with less job creation and less tax revenue, and getting the perverse result that government borrowing might actually increase.

My tax elasticity calculations suggests that tax revenue moves 10% more than changes in GDP. In other words, a 1% increase in GDP increases tax revenue by 1.1%, and vice versa. That suggests the best way to cut our government debt overhang isn’t to reduce government spending, but to make sure to maintain the current level of spending, and redirect it to growth positive and useful projects.

If we can get efficiency gains and reduce wastage and leakages, the surplus cash shouldn’t be used to reduce debt but be spent on other growth generating projects, like soft and hard infrastructure (such as education). Otherwise, you risk a reduction in aggregate demand and cut growth, cut tax revenue growth, and not see a whit of improvement in either the economy or in the fiscal balance.

To use the household analogy that many people are fond of, cutting spending does work but only if you assume that your income is fairly constant. But in the case of government, cutting spending reduces your income at the same time and to an even greater degree, thus making things worse, not better. To avoid this pickle, you need somebody to take up the spending slack – so fiscal austerity only works if the economy is not only growing but growing faster than capacity can be added, where private spending can displace government spending without reducing incomes and jobs.

But I’m fairly sure that this argument will go right over the heads of a lot of people.

Technical Notes:

“On the Brink: Fiscal Austerity Threatens a Global Recession", UNCTAD Policy Brief No 24, December 2011 (warning: pdf link)