Painful Medicine

2011 September 25
by SJ Leeds

Before I get to this week’s blog, I was quoted in the Houston Chronicle on Friday.  The article is titled, “Fed Shoots Blanks as Worries Rise” and it was written by Loren Steffy.  Here’s the link.  I thought that Loren wrote a great article.  Now, on to today’s topic…


The IMF put out a short piece (“Painful Medicine” by Laurence Ball, Daniel Leigh and Prakash Loungani in the IMF’s Finance and Development publication) about the effect of austerity measures on economies.  (This was based on a longer piece of research that the IMF had published.)  Ultimately, they refute the idea that deficit reduction will lead to stronger growth and job creation in the short run.  They are not arguing that deficit reduction is bad or that it won’t help in the intermediate to long-term; rather, they are just saying that it will hurt in the short term.


The authors rely on recent IMF research showing that “over the past 30 years, consolidation lowers incomes in the short-term, with wage-earnings take more of a hit than others; it also raises unemployment, particularly long-term unemployment.”  This paper is significant because (if they are right), it tells us that we’re heading for a really long period of economic pain.  Below, you will find the key ideas (with many lifted directly from the paper and all charts are also their work).


The Problem

1. For advanced economies, there is an unmistakable need to restore fiscal sustainability through credible consolidation plans.  See Chart 1.

2. Public debt has increased in many countries due to the Great Recession: lower income, lower taxes, bailouts and stimulus.  Public debt in advanced economies has increased from 70% of GDP to approximately 100% of GDP.  This is the highest level in 50 years.  The problems are even more serious due to the aging population.

3. Many countries are trying to reduce debt by cutting spending and increasing taxes.


The Evidence

1. Over the past 30 years, there have been 173 episodes during which 17 advanced economies undertook budgetary measures aimed at fiscal consolidation.

2. The average size of fiscal consolidation was approximately 1% of GDP per year.

3. Fiscal consolidation raises unemployment and lowers income.  See chart 2.

4. A fiscal consolidation of 1% of GDP reduces inflation-adjusted incomes by about .6% and raises the unemployment rate by almost .5% within two years.

5. Spending by households and firms also declines.  There is no evidence of a handoff from the public to private sector.


Reducing the Pain

1. The reduction in incomes is even larger if central banks do not or cannot blunt some of the pain through monetary policy.  Lowering interest rates supports investment and consumption.

2. Unfortunately, in today’s market, central banks can do little because rates are already near zero.

3. If many countries carry out austerity at same time, the reduction in incomes in each country is likely to be greater, since not all countries can reduce the value of their currency and increase net exports at the same time.

4. Simulations show that reduction in incomes may be more than twice as large as that described above when many countries are carrying out consolidations at the same time.  The contractionary effect may be greater than historical events.

5. Historically, fiscal consolidations based on spending cuts are less painful than those based on tax hikes.  But, this has been true because central banks have cut interest rates more after spending cuts.

6. Fiscal consolidation may also seem less painful when markets are more concerned about the risk of a government defaulting on its debt.  In other words, if a country is tackling its fiscal situation, this can give confidence to investors, consumers and firms and can lead to more spending.  But, IMF research shows that these consolidations are still contractionary and there is no evidence of any surge in consumption and investment.


Long-Term Pain

1. Fiscal contraction has a bigger impact on long-term unemployment (when an individual is unemployed for longer than six months).  While the increase in short-term unemployment ends within three yeas, long-term unemployment remains higher after five years.  Fiscal consolidation hurts those who are already suffering.  See Chart 3.

2. Long spells of unemployment reduce the odds of being hired.  In the US today, a person unemployed for more than six months has only a one-in-ten chance of being rehired in the next month, compared with a one-in-three chance for a person unemployed less than a month.

3. Long-term unemployment also threatens social cohesion.  A survey conducted in 69 countries found that an experience with unemployment leads to more negative opinions about the effectiveness of democracy.  The effects were more pronounced for the long-term unemployed.



1. For every 1% of GDP of fiscal consolidation, inflation-adjusted wage income typically shrinks by .9%, while inflation-adjusted profit and rents fall by only .3%.  Also, while the decline in wage income persists over time, the decline in profits and rents is short-lived.  See Chart 4.

2. Possible reasons for this include: austerity plans often call for public sector wage cuts and consolidations also increase unemployment.


The Bottom Line

1. We should have realistic expectations about short-term consequences of fiscal consolidation.  It is likely to lower incomes (hitting wage-earners more than others), raise unemployment (particularly longer-term unemployment) and will slow growth.

2. The potential benefits of consolidation are longer-term: reducing interest rates and lightening the burden of interest payments, permitting cuts to distortionary taxes (those that discourage desirable behavior).

3. We need to approve fiscal measures now that will kick in to reduce deficits in the future.  We need to link retirement age to life expectancy and improve the efficiency of entitlement programs.

4. In countries like the US (where unemployment is at high levels and long-term unemployment is at alarming levels), there is a need for policies to spur job creation and increase consumer confidence, including measures such as mortgage relief for distressed homeowners.

5. Fiscal consolidation plans should also spell out how policies would respond to shocks, such as slower growth than planned.  Fiscal plans succeed when they permit “some flexibility” while credibly preserving the medium-term consolidation objectives.


My Thoughts

I believe the authors are spot-on…we’re headed for significant pain.  Government spending is a significant part of our GDP.  It’s going to impact our growth when we cut this.  When we increase our taxes, that’s money that individuals won’t be spending.  Individuals are deleveraging and we’re also going to eventually need to do this collectively (with our public debt).  This isn’t a problem that is going to be solved in the next few years.  REMEMBER: this study explains what happens when we have fiscal consolidation that is 1% of GDP.  Our fiscal gap is closer to 8% of GDP. I believe that we’re headed for long-term slow growth that will impact financial returns, employment and wages.  I also believe that we’re headed for a time in which we see a further bifurcation between “the haves” and the “have-nots.”  This isn’t a short-term economic cycle.  It’s going to be a long-term economic reality.  The “new normal” should be called the “ugly new normal.”


Have a great week.

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