on the brink: fiscal austerity threatens a global recession

8/3/2019 On the brink: fiscal austerity threatens a glObal recessiOn

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On the brink: fiscal austerity threatens a glObal recessiOn

Due to sluggish private demand, several advanced economies are hovering on thebrink o a second bout o recession. Yet, in many o these countries political attentionhas turned to ways to cut fscal defcits and reduce the domestic public debt. This hascreated a dangerous accumulation o risks or the world economy. The private sector canonly success ully deleverage (i.e., reduce its debt) i someone else is willing to take onhigher debt and support demand. I the private and the public sectors try to deleveragesimultaneously, they must either fnd debtors elsewhere, or the economy will tailspin intoa depression. As the developing world is both unable and unwilling to accept the role odebtor o last resort, dangerous pressures are building up. Unless there is a rapid policyturnaround, the world is in danger o repeating the mistakes o the 1930s. In todays highlyintegrated global economy, the contractionary contagion will a ect all countries. Emergingand developing economies need to prepare contingency plans.

another fne messDuring 2011, most advanced economieseither suspended or reversed the expansionarypolicies that had helped to avert the worst

symptoms o the global economic crisis.Several governments hoped to bring about anexpansionary contraction where scal restraintwould improve private sector con denceand oster a wave o private investment andconsumption demand. These hopes are rapidlywaning as new data points unambiguouslyto a ully-fedged recession in key advancedeconomies in 2012. The pain has brought nogain. UNCTAD and others had warned earlyon that expansionary scal contraction waswish ul thinking at best. Following in the ootstepso many developing countries since the early1980s, most advanced countries implementingausterity policies have experienced, instead,a contractionary contraction. Private sectorcon dence is reaching new lows, as demand

rom governments and rom public sectoremployees alls relentlessly. The new head o theIMF, Christine Lagarde, echoed UNCTAD whenshe warned the world economy has entereda dangerous new phase. The vicious circleinduced by scal contraction, weak nancialinstitutions and nancially ragile households is

uelling a crisis o con dence and holding back

investment and job creation in the private andpublic sectors simultaneously.

The disappointing results o expansionarycontraction illustrate persistent and undamentalmisconceptions about the unctioning o the

U n i t e d n a t i o n s C o n f e r e n C e o n t r a d e a n d d e v e l o p m e n t

key points High unemployment

is a more pressingproblem now than

scal imbalances. Fiscal austerity in the

current environmentwill make mattersworse, not better.

Contractionary

contagion willeffect all countries-- emerging anddeveloping economiesneed to preparecontingency plans.

P O

L I C Y B

R I E F

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macroeconomy. The Trade and DevelopmentReport (2011) reviews scores o cases where

scal tightening did not trigger the sought-a ter macroeconomic expansion but, rather,

had the opposite e ect. These include a longlist o developing countries, whose damagingexperiences in the last three decades ought toencourage current policymakers to do better.Chart 1 (A and B), below, summarises theexperiences o countries receiving emergencyIMF support during the nancial crises o the late 1990s and early 2000s and alsoduring the present crisis. Chart 1.A contraststhe orecasted impact on GDP growth o contractionary policies in these economies (inthe horizontal axis), as expected in the Letterso Intent signed between the IMF and nationalgovernments, with their outcomes (in thevertical axis). Scatterpoints along the 45 degreeline indicate cases where the expectationshad proven to be correct. Points above thatline indicate countries where the outcomes

D E C E M B E R 2 0 11


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Chart sources: UNCTAD(TDR 2011); IMF, Letters ofIntent, accessible at http://

www.imf.org/external/ np/cpid/default.aspx and

UNCTAD Globstat

A. GDP growth (Per cent)

B. General government balance (Per cent of GDP)

TUR 99

RUS 99

ARG 01

-20

-15

-10

-5

0

5

10

15

20

Forecast

A c

t u a

l

TUR 99

THA 98

RUS 99

PHI 99

KOR 98

IND 98

BRA 99

ARG 01

-20

-15

-10

-5

0

5

10

15

20

-20 -15 -10 -5 0 5 10 15 20 -20 -15 -10 -5 0 5 10 15 20

-20 -15 -10 -5 0 5 10 15 20 -20 -15 - 10 -5 0 5 10 15 20

Forecast

A c

t u a

l

GEO 09GRE 10

HUN 09

ICE 09

LAT 09

PAK 09

ROM 10

SER 09UKR 09

-20

-15

-10

-5

0

5

10

15

20

Forecast

A c

t u a

l

GEO 09

GRE 10

HUN 09

ICE 09

LAT 09

PAK 09

ROM 10SER 09

UKR 09

-20

-15

-10

-5

0

5

10

15

20

Forecast

A c

t u a

l

THA 98

PHI 99

KOR 98

IND 98

BRA 99

Chart 1: Comparisons between orecasts o gdp growth and fscal balances in im -sponsored programmes and actual values(selected country/year )

dozens o developing countries since the early1980s. Most tellingly, a detailed examinationo the impact o scal adjustment in 133 IMF-supported programmes in 70 countries, carriedout by the IMFs own Independent EvaluationO ce (IEO) noted a tendency to adopt scal targets based on overoptimistic assumptions

about the pace o economic recovery leading inevitably to scal underper ormance andoveroptimistic assumptions about the pace o

revival o private investment. (IMF, 2003: vii). The lesson that scal tightening systematically

ails to deliver scal consolidation is importantor countries in the current crisis, and or those

that are reeling under the pressure o declininggrowth orecasts.

Further historical insights that resonate todaycan be gleaned rom the Great Depressionin the US, which actually included two sharpdownturns in succession. During the rst wave(August 1929 to March 1933), GDP ell sharplyeach year until 1932, and declined modestly in1933. Unemployment rose to unprecedentedlevels. The recovery started a ter PresidentF.D. Roosevelt took o ce, in 1933, with annualreal GDP growth exceeding 9 per cent andunemployment alling sharply. However, growthwas halted by another severe downturn in1937-38, when real GDP ell by 3.4 per centand unemployment surged to 19 per cent. Itis now generally accepted that the seconddownturn was induced by poor government

policy, especially the decision to tighten upscal policy too early in the recovery.

exceeded expectations, and points below the45 degree line are countries where expectationswere not achieved. It is evident on inspectionthat in virtually all countries the policy outcomeshave systematically and unambiguously notmet expectations. In some cases the gaps aresubstantial: in 1998, a GDP growth orecast o 5per cent or Indonesia actually came in at minus13 per cent, while Thailand was expectedto achieve 3.5 per cent growth but actuallycontracted by 10.5 per cent. Similarly, in 2009,Latvia and Ukraine experienced a staggering allin GDP that was three times as large as thatanticipated.

Given that GDP growth was normally muchlower than had been anticipated, it is notsurprising that scal balances were also worsethan expected (chart 1.B). When GDP growth

alters, tax revenues are also likely to allbelow expectations. At the same time, publicexpenditures are bound to overshoot becauseo the higher than expected bene ts andsocial security payments and other trans erswhich must be made when the economyslows down. The passive but strongly positiverole o these automatic stabilisers has beenwidely understood since the 1930s. It wasalso widely known that it is counterproductiveto raise taxes or cut public spending duringa recession because a scal contraction canunleash a vicious circle o economic decline.

The adverse impact o many recent policy

experiences could have been anticipated, in thelight o economic theory and the experiences o


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Todays scal de cits arethe consequence of thecrisis, not its cause(chart 2).

In developed countriesfrom 1997-2008, theprimary scal balanceranged from -1.5% to+3.2% of GDP, while theoverall balance rangedfrom -4.3 to -0.4%.

On average, the primarybalance during thisperiod was 0.8% andthe overall balance-2.4% of GDP. (Evenwhen factoring in thecrisis years, the primarybalance during 1997-2010 was on averageonly -0.1% and theoverall balance -3.3%.)It was only AFTER thecrisis that de cits slidto todays levels.

Growth, and not thede cit, is the appropriatetarget for the moment.

in the Eurozone do not issue the currency inwhich they are indebted, and they do not havea reliable lender o last resort. Moreover, there isadded currency risk rom the (unstated) optionto leave the Monetary Union. Experiences inEast Asia, Latin America, sub-Saharan A ricaand other developing areas a ected by systemiccrises suggest that interest rates and spreadswithin the Eurozone can decline only i thecompetitiveness gap in its peripheral countries isaddressed e ectively, while Germany stimulatesits domestic demand. In the meantime, the

nancing needs o the peripheral countriescould be bridged by eurobonds and/or byunlimited interventions o the ECB on the bondmarkets, which could bring interest rates downto bearable levels or the a ected countries.

a new poli y ppro his needed

The world stands on the brink o a double-

dip recession and a lost decade or manycountries. UNCTAD calls or a concerted andco-ordinated expansionary policy alternativeincluding the ollowing key elements:* The countries threatened by recession and defation should avoid intensi ed austerity

measures because these are unlikely to producethe intended outcomes and could propel theworld into a renewed bout o recession, or even into an outright depression. Without anincrease in domestic demand, employmentand wages in the surplus countries, the mostlikely outcome would be a new round o globaleconomic contraction. This is likely to trigger aripple o adverse e ects at the international level,including a collapse in trade and investment andgrowing pressures or protectionism.

Mis on eptions bout debtnd interest r tes

It is o ten claimed and repeating theconventional economic wisdom o the 1920s-- that scal austerity is necessary in order tomaintain the con dence o the nancial marketsin the sustainability o government budgets, andto avoid infation and damaging interest ratehikes which would compromise the economic

recovery. However, the European exampledoes not support the case or austerity. Despitethe panic in some markets, and a temporaryincrease o the ECB short-term policy rate byaround 0.5 per cent in the Spring o 2011,average bond yields in the Eurozone rose only

rom 3.3 per cent in October 2010 to 4.1 percent in October 2011. In the same vein, Japan,the most heavily indebted advanced countrygovernment, also enjoys the worlds lowestlong-term interest rate, and the United States,with a government debt close to 100 per cent o

GDP, also enjoys historically low interest rates. The large dispersion in interest rates betweenmembers o the Eurozone which emerged in thea termath o the 2008 nancial crisis has othersources than government debt. For example,although as a percentage o GDP Spainsgovernment debt is smaller than Germanys, thecountry pays a much higher risk premium. TheEurozone countries penalised with high spreadsvis--vis Germany are not those with high scalde cits or government debt but, instead, thoserunning signi cant current account de cits. The

nancial crises in several developing countriesalso rein orce the argument that the spreadover hard currency interest rates refect mainlya currency risk , rather than a genuine risk o government de ault. The vulnerable countries

Chart 2: Government revenues and expenditure and fscal balance, Developed economies,1997-2010 (% o current GDP, weightedaverage)

10

15

20

25

30

35

40

45

50

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

-10

-8

-5

-3

0

3

5

8

10

Government revenues Government expenditurePrimary scal balance (right axis) Overall scal balance (right axis)


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Reference

UNCTAD (TDR 2011), Trade and Development Report, 2011, Post-crisis policy challenges in the world economy,United Nations publications, Sales No. E11.II.D.3, New York and Geneva.

Electronic versions o this report and related material can be ound on http://www.unctad.org/Templates/WebFlyer.asp?intItemID=6060&lang=1

cont tHeiner Flassbeck,

Director, UNCTAD, Tel. +41 22 917 60 48

[email protected] O ce

+41 22 917 58 [email protected]

www.unctad.org

*Fiscal space can protect vulnerable economies

against external shocks . Countries should seekto enlarge their scal space through the useo appropriate tax policies, and by building upa strong scal position in times o economicprosperity. Some o the transition economiesdepicted in the charts above experienced aparticularly hard landing during the recent crisis,because their scal space had been severelyreduced by imposing very low tax rates overseveral years. This gave them little room tomanoeuvre when crisis struck, as they oundthemselves unable to put into place the stimulus

measures used in other countries.

con lusion There is a very real risk o new economic criseserupting and, in todays highly integrated worldeconomy; their impact will not be limited tospeci c sectors or to well-de ned regions. TheG-20 initially recognised this act, but recentactions have not been consistent. In particular,the scal restraint in the countries with currentaccount surpluses and very low long-runinterest rates in Europe, point precisely in the

wrong direction. A ragile global economy hasa signi cant interest in the implementation o expansionary, rather than contractionary scalpolicies in key economies. Only the ormer canopen a path towards lower scal de cits and

alling public debt ratios. A lost decade orthe world economy would risk the developmentgains achieved during the recent years, andthrow into question the ability o democraticgovernments to tackle the most urgentchallenges o our age.

* Countries should see scal policies astools or growth and development, instead o automatically adopting a scal-phobic

approach. Instead o asking whether their scal de cit is too big, they sould consider

whether it is being used in the best way to

stimulate the economy. In the corporate sector,high levels o debt are typically justi able i theborrowing costs are tolerable and the debt is

nancing sustainable pro t streams and long-term rm growth. This approach is even moreappropriate in the case o government debtbecause the current scal de cits are theconsequence rather than the cause o theongoing crisis (chart 2): in many cases, thesede cits are due to the trans er o private sectordebts to the public sector, making them thewrong target or scal policy. Most importantly,

however, in terms o global economic revival isthe act that, given the current lack o investorand household con dence, governments mustplay the role o growth engine o last resort.Income can be generated only i somebodyspends, and experience suggests that, in arecession, the only someone available is o tenthe government.

* Fiscal space can be shrunk or expanded according to the mix o policies that governmentschoose to implement, with a variable impact

on employment, tax revenues and economic growth. In the countries depicted in charts1.A and 1.B, tighter scal policies o ten led toreduced investment, job losses, reduced scalrevenues, and stagnant or alling GDP growth.In contrast, expansionary scal policy can boostconsumer demand and employment; it can alsoincrease public investment directly, and it canindirectly stimulate private-sector investmentand incomes. These can lead to higher taxrevenues and a lower scal de cit, even i taxrates remain unchanged. Social spending in

such areas as unemployment bene ts, healthand housing can also be seen as promotingrecovery as they sustain consumption duringthe crisis, in addition to their direct impact uponpoverty. Similarly, distinct tax policies can havevery di erent e ects on the scal balance: taxcuts that bene t lower income households canhave a stronger impact on aggregate demandthan cuts aimed at high-income households,because poorer households are likely to spenda larger share o their revenues.

on the brink: fiscal austerity threatens a global recession

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