Fiscal Consolidations to Cripple Growth in 2023?

Summary

• A new Economic Modelling paper provides a succinct overview on the short- to medium-term impacts of fiscal consolidations in OECD countries.
• They find that government cutbacks are rarely positive for growth, but are even worse for more indebted countries going through pronounced recessions.
• The prevailing monetary policy stance is also important. If the central bank is hiking too, the GDP effects are even worse and, as a result, the debt-to-GDP ratio actually increases after fiscal consolidations!
• The authors also show that revenue-based consolidations are less harmful to growth during recessions and under tight monetary conditions than expenditure-based ones. Perhaps then, we can expect more of these in 2023!

Introduction

The unprecedented fiscal expansions in most countries during the pandemic has rapidly expanded public debt. These burdens are becoming increasingly expensive to service as interest rates creep higher.

In the US, net interest payments rose 35% over the last fiscal year and, in real terms, they have never been higher. In fact, on an annualised basis, gross payments are now equivalent to whole US defence budget!

It’s not unrealistic to assume, therefore, that governments will (if they haven’t already) introduce substantial fiscal consolidations in 2023. A new journal paper reviews the impacts of such cutbacks on key macroeconomic variables, and to what extent these are influenced by prevailing economic headwinds.

Data and Methodology

The authors use annual data from 24 OECD countries from 1990 to 2019. To identify ‘fiscal consolidations’, they look at changes in a country’s cyclically adjusted primary balance (CAPB) as a percentage of their potential GDP.

The CAPB has become a popular variable in the fiscal literature, as it removes the automatic component (e.g. income tax and benefits) of government spending or revenue. This component varies with economic conditions and therefore is largely beyond the control of governments unlike, say, health care or education spending.

The macroeconomic variables collected in the paper are real GDP, the unemployment rate, inflation, consumption, investment, exports, imports and the debt-to-GDP ratio. The aim is to understand how fiscal consolidations affect each of these unconditionally, but also conditional on four other prevailing conditions:

1. Whether the economy is in recession or growing above average.
2. Whether public debt is high (90% of GDP), intermediate (60-90%) or low (<60%).
3. Whether monetary policy conditions are loose or tight.
4. Whether a country has a high or low degree of trade openness.

Fiscal Consolidations Reduce Public Debt at the Cost of Growth

Starting with the unconditional results, fiscal consolidations typically harm real GDP growth (Chart 1a). The impact is felt most in year two, falling 0.62%, but recuperates after four years. As real GDP declines, the unemployment rate rises, although not too significantly (Chart 1b). Inflation also increases slightly as the home currency appreciates in response to a credible debt reduction strategy (Charts 1c & 1d).

Unless…

Next, the authors check the responses under different macroeconomic contexts.

Starting with fiscal consolidations undertaken in recessions. Typically, the decline in real GDP is much more pronounced (Chart 2a), falling twice as much as the unconditional scenario. As a result, the unemployment rate increases by more, but inflation declines. The negative economic impact reduces government revenues and increases benefits, which means the public debt ratio doesn’t fall by as much (Chart 2b).

In expansions, the responses are the opposite. After four years, real GDP may in fact even be higher than pre-consolidation (Chart 2a), and the unemployment rate doesn’t change throughout. Defiantly, the public debt ratio also declines by more than in recessions (Chart 2b), making fiscal consolidations far more attractive to undertake in better economic conditions.

Moving onto the starting debt level in an economy pre-consolidation. If it’s above 90%, as it is in the US, Canada, UK, Spain, Italy, Greece and Japan (among others), the impacts of fiscal consolidations are usually more severe. GDP falls by twice the average (Chart 2c) and the public debt ratio may actually increase in the short-term as a result (Chart 2d).

Less indebted countries, on the other hand, will actually see a rise in GDP levels after fiscal consolidations (Chart 2c). This allows the unemployment rate to fall, with the additional benefit that inflation remains unchanged. Moreover, the public debt ratio drops by twice the average level (Chart 2d).

Monetary Policy and Trade

The two remaining macroeconomic contexts are fiscal consolidations undertaken when monetary policy is loose or tight, or when a country is open or not.

When monetary policy is tight, there is a larger-than-average decline in GDP. Growth remain depressed for the full four years, which leads to a higher unemployment rate. At the same time, inflation rises in year one, but then falls by year four. And, the reward for all of this is actually a rise in the debt-to-GDP level – the exact opposite of what a government would hope for with fiscal contractions!

The same results hold for countries that are less open to trade. However, even with a similar output decline and unemployment rise as above, the debt-to-GDP ratio decline after four years.

The Type of Policy Matters

Next, the authors examine the effects of revenue- versus spending-based fiscal consolidations. I’ll only summarise the impacts in scenarios that I believe are relevant to the current economic climate.

Starting with the average impact, both types of consolidations have a similar impact on growth for the first two years (Chart 3a). Thereafter, expenditure-based policies are less harmful, and even beneficial, for growth. These policies also have a larger deflationary impact than revenue-based ones, but otherwise have similar effects on the unemployment rate and debt-to-GDP ratios.

Expenditure-based fiscal consolidations lose their upper-hand during recessions. Typically, they have a larger negative impact on growth relative to revenue-based policies (Chart 3b). Revenue-based policies also appear less harmful for growth under tight monetary conditions (Chart 3c). Meanwhile, the impacts of both types of policies in more indebted countries are similar (Chart 3d).

Bottom Line

The paper is straightforward in its approach, but offers a great high-level overview of the impacts of fiscal consolidations on key macroeconomic variables. The results suggest a challenging period ahead for some countries, like the UK. A highly indebted country with weak growth and a hiking central bank, the Sunak government could cause a relatively strong recessionary impact with fiscal consolidations. In doing so, there is also no guarantee that the debt-to-GDP ratio will fall, making it a painful undertaking with few benefits.