THE GREAT FALSE CHOICE, STIMULUS OR AUSTERITY / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

The great false choice, stimulus or austerity

By Olivier Blanchard and Carlo Cottarelli

Published: August 11 2010 21:58

The debate on the need for further fiscal stimulus or quicker retrenchment has become too ideological, and too extreme. Underneath it, however, there is more agreement on the basics than may be apparent at first blush. Indeed, despite the warring comments that have appeared in these pages, there is actually no necessary conflict between restoring fiscal sustainability and maintaining support for the recovery.

Despite rising fears of a double-dip recession in both the US and UK in recent days, the basic facts remain unchallenged. Government debt in advanced Group of 20 countries will reach 115 per cent of gross domestic product by 2015 – almost 40 percentage points above pre-crisis levels. Some commentators look at these numbers and question the earlier fiscal stimulus. But only a 10th of this new debt is attributable to those attempts to boost their economies. The vast majority is due to the recession, and related revenue losses. No one believes that budgets should have been cut to offset this revenue loss. Indeed, allowing deficits to increase put a floor under what otherwise would have been a calamitous collapse in demand.

Today’s debt problems, therefore, result not from how fiscal policy was managed during the crisis, but rather from how it was mismanaged before the crisis. Advanced countries entered the crisis with some of the highest public debt ratios ever reached in the absence of a major war. A basic fiscal policy lesson of sowing in good times and reaping in bad times was ignored.

The future goal is to achieve what the G20 terms “strong, sustainable, and balanced growth”. This surely requires a return to fiscal sustainability, which demands credible medium-term fiscal plans. The first goal should be to stabilise debt-to-GDP ratios. To do this over the next five years means an average improvement in structural budget deficits of 1 per cent a year in G20 countries. Continuing roughly at this rate for five more years and then stabilising would bring down average debt levels to 60 per cent of GDP by 2030.

None of this should be controversial. Indeed, the divisions between fiscal tightening advocates and their opponents are often more apparent than real. The former are usually really talking about tightening in the 2011 budget cycle; from a fiscal standpoint, 2010 is already behind us. The latter are not always opposed to lower deficits in 2011, given the scale of the current stimulus that is now being withdrawn as planned.

Still, some clearly prefer more front-loaded consolidation, others less. Front-loaders point to the need to maintain credible fiscal policy, which is hard to gain and easy to lose. They note that market perceptions of fiscal health can shift in a heartbeat, so countries must move pre-emptively.

Back-loaders respond that, if hasty adjustment derails growth, credibility will also be a casualty. To use Larry Summers’ apt expression, recent growth numbers show that advanced economies have not yet achieved escape velocity. Withdrawing fiscal accommodation too early could therefore jeopardise the recovery, especially when – measures announced this week by the Fed notwithstanding – the monetary policy arsenal has been effectively drained. When private demand picks up, they argue, consolidation will be easier and safer.

Fortunately, there is a path through these thorns. Front-loading can be avoided if moderate adjustment today comes with further savings in the future. And such options are available, desirable and, in many cases, more politically feasible than front-loaded spending cuts. Take reforms of pensions and health. An increase in the retirement age by two years would reduce the deficit by 1 percentage point of GDP. Stronger fiscal institutions – including fiscal rules, budgetary processes and independent fiscal agencies – can also go a long way. Such reforms are unlikely to affect demand in the short run. Indeed, an increase in the retirement age may even decrease the need for private saving, and thus increase consumption.

Realistically, however, credibility requires an initial down payment and, for most countries, this means putting adjustment plans in place today. In 2011, most of the adjustment currently envisaged by G20 countries – about 1¼ percentage points of GDP on average – comes from expiring fiscal stimulus. This seems appropriate, so long as private demand gathers steam as currently forecast.

But more important are measures that improve the long-term fiscal outlook in those countries with high deficits and debt. This is where governments should focus their efforts. For without long-term fiscal reforms, lasting recovery is doomed far more certainly than if the world gets 2011 plans wrong by a fraction of a per cent of GDP.

The writers are chief economist and head of fiscal affairs at the IMF


Copyright The Financial Times Limited 2010