Fiscal tightening and growth

A good squeeze

Bigger budgetary adjustments are not always better

ACROSS much of the rich world an era of budget austerity beckons. Government debt is rising faster than at any time since the second world war. By 2014 the public debt of big rich countries will reach an average of 110% of GDP, up by almost 40 percentage points from 2007, according to the IMF (see chart). On current policies it will continue rising.

How to alter this bleak trajectory will be policymakers’ most difficult task over the next decade. Financial markets are already forcing some into drastic action. Greece plans to cut its deficit from 12.7% of GDP in 2009 to 3% by 2013, using spending cuts, tax hikes and heroic growth projections. Portugal has rushed out plans to cut its deficit from 9.3% last year to 3% by 2013. Britain’s election will be fought over the contours of future austerity.

But so far less than half of the OECD’s member countries have detailed medium-term plans to reduce their deficits. Their choices will have huge implications for the growth and structure of their economies. Worryingly given the stakes, economics offers surprisingly little certainty about either the optimal goal or the best way of getting there.

Begin with the goal. Today’s deficits, which are leading to ever-higher debt burdens, are plainly unsustainable. But what level of public debt should governments aim for? A popular rule of thumb for a “safe” level of government debt in a rich economy is 60% of GDP. That is the limit enshrined in the Maastricht Treaty, which governs membership of the euro. It was the average debt-to-GDP ratio among big rich economies before the financial crisis. And it is the figure to which the IMF reckons rich countries should aspire.

Reducing debt burdens to pre-crisis levels may make some sense. It would ensure the costs of the crisis were not passed on to future generations. It would leave governments with more fiscal room to deal with recessions to come. And it would ensure that higher government debt did not crowd out private investment, which could lower future growth. The fund reckons that the 35-percentage-point increase in rich countries’ debt could raise borrowing costs by two percentage points.

Unfortunately, there is little rigorous evidence in support of a target of 60%, let alone for reaching it quickly. In the past some countries’ public-debt ratios have been higher than they are today and they have often fallen slowly. Andrew Scott of the London Business School points out that Britain’s debt burden rose from 121% of GNP in 1918 to 191% in 1932 and did not return to its 1918 level until 1960. In a recent study Carmen Reinhart and Ken Rogoff find that public-debt burdens of less than 90% of GDP have scant impact on growth, but they do see a significant effect at higher ratios. That argues against a single number for all. With the world’s biggest sovereign-bond market and trusted institutions, America will be able to carry a higher public-debt burden than Greece.

In principle, countries can cut their debts in several ways. They can default, either outright or, if they have their own currencies, through inflation. For most countries, these paths are unappealing (see article). They can try to boost growth, which reduces the burden of public debt and makes it easier to cut deficits by bringing in more tax revenue. But the size of today’s deficits—on top of the future cost of existing pension and health-care promises—means growth alone will not be enough. Budgets also have to be tightened.

By how much depends on governments’ debt goals. The IMF’s calculations, for instance, suggest that to reduce their ratios of public debt to GDP to 60% by 2030, the rich world’s governments need to improve their budget balances by an average of 8% of GDP by 2020. The average structural deficit (ie, before interest payments) must swing from 4.3% of GDP in 2010 to a surplus of 3.7%. They must then maintain that surplus. A fifth of the rich world’s economies (including America and Britain) would need adjustments of around 10% of GDP or more. Stabilising debt ratios at 2012 levels would demand, on average, an adjustment only half as big.

The appropriate debt-to-GDP goal will depend on the means used to get there. Balancing a budget by raising taxes, for instance, may harm growth more than living with a higher debt ratio. Here, the academic evidence is clearer. Fiscal adjustments that rely on spending cuts are more sustainable and friendlier to growth than those that rely on tax hikes. Studies show that cutting public-sector wages and transfers is better than cutting public investment. Many cuts, from raising pension ages to slashing farm subsidies, have a double benefit: they boost growth both by improving public finances and by encouraging people to work harder or promoting more efficient allocation of resources.

Austerity can even be expansionary. A number of budget adjustments based on spending cuts in the 1980s and 1990s were accompanied by faster growth, presumably because the effect on confidence and interest rates outweighed the loss of government demand. That may not happen again, not least because consumers are weighed down with debt and interest rates are already so low. But the superiority of spending cuts still holds. The problem, however, is that the scale of adjustment may be too big to achieve by cuts alone. The IMF’s analysts, for instance, reckon that three percentage points of the 8% of GDP fiscal swing they deem necessary will have to come from higher tax revenue.

The taxes that do least harm to growth are those on consumption or on immobile assets such as property. Given the pressures of global warming, green taxes also make sense. European governments already rely more on consumption taxes than other rich countries do, and some are raising their rates of value-added tax. But politics often points elsewhere, towards making rich people pay to clean up the fiscal mess: the highest marginal rates of income tax are set to rise in America and Britain. That may please populists but it will not boost growth.