20th February 2012
This piece from FTSE Global Markets outlines the debate : "If we look back at some of the examples of fiscal consolidation in the 1990s, it is clear that they were successful because the fiscal deficit was permanently corrected (this is the case in Canada, Sweden, Finland, Denmark, Italy and Ireland). Moreover, economic growth was not weakened; quite the contrary in fact. Unemployment declined in all cases, except in Italy."
"The current debate centres around whether this was achieved because of so-called ‘Ricardian neutrality' (in other words, a fall in the savings rate because of expectations of a lower tax burden at some point in the future due to cuts in government expenditure); or whether it was due to expansionary monetary policies and exchange-rate depreciation, and thereby to the stimulation of credit, investment and exports."
The message for policymakers is that if ‘Ricardian neutrality' has delivered more successful fiscal consolidations, then Eurozone countries should prioritise government spending cuts to reduce fiscal deficits. It also means that the fact they cannot devalue their currency is not as much of a barrier to rebuilding their economies as has been thought.
This study from Italian academic Roberto Perotti looks at the experience of Denmark, Finland, Sweden and Ireland – He analysed fiscal consolidation achieved by currency devaluation and that achieved by austerity measures. He suggests that that achieved by austerity measures tended to promote the greater expansion because it addressed an economy's competitiveness.
He says: "All four consolidations were associated with an expansion; but only in Denmark the driver of growth was internal demand. However, as in most exchange rate based stabilizations, after three years a long slump set in as the economy lost competitiveness."
Prioritising exports was also extremely important. He believes that the Denmark situation should be of particular interest for small EMU members today: "Denmark relied on an internal devaluation via wage restraint and income policies as a substitute for a devaluation. It exhibited all the typical features of an exchange-rate based stabilization. Inflation and interest rates fell fast, domestic demand initially boomed; but as competitiveness slowly worsened, the current account started worsening, and eventually growth ground to a halt and consumption declined for three years. The slump lasted for several years."
He added that private consumption typically increased one-and-a-half to two years after the start of the consolidation. In all cases, wage moderation was essential to maintain the benefits of the depreciations and to make possible the decline of the long nominal rates.
Mexico learned this lesson through bitter experience and theirs was an experience seen in a number of emerging market countries. It had already four years of recession before the government forged a joint agreement with official leaders of the labour, peasant, and business sectors to restrain wages and prices. This finally acted to curb the inflation that had held back economic progress since the start of the crisis in 1982.
This country study from the US Library of Congress gives a neat outline of the Mexican situation : "This two-stage program called for "shock" treatment in 1983 to restore macroeconomic balance, to be followed in 1984 and 1985 by a "gradualist" adjustment program to open the economy to market forces. The first phase was intended to restore price and financial stability by means of a sharp reduction in public spending and a steep peso devaluation. The government instituted a harsh austerity regime that held the growth in domestic spending far below the rise in total output.
"De la Madrid's first stabilization package did not work as expected. The government had expected lower inflation and more realistic prices to produce strong economic growth by 1984. This did not take place…The austerity measures and devaluations of 1983 eliminated both the fiscal and trade deficits, but at the cost of sharply reduced imports and a severe economic recession. Contrary to expectations, the inflation rate did not fall significantly, and voluntary private lending did not resume." Shifting the development strategy towards exports in 1985 helped the situation slightly, but it was only tackling inflation that really solved Mexico's problems and it still did not save it from another crisis in 1995.
None of these situations can completely reveal the likely outcome of the Eurozone crisis, particularly because elected governments are now not always in charge of their own destiny. In most cases, the debts were nowhere near the scale of those in Greece or other peripheral European countries. However, history reveals that economic expansion is possible after fiscal consolidation, and austerity measures have worked to achieve that, but only when combined with a pick-up in exports and inflation controls. As is becoming increasingly clear in the Eurozone, only one side of the equation – austerity – has been addressed.
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