"Even if Austerity Works, It Should Be Delayed as Long as Possible."
Not if you want to kick-start growth as soon as possible. At the annual IMF meeting in Tokyo last October, the fund's managing director, Christine Lagarde, told crisis countries to abstain from front-loading spending cuts and tax increases: "It's sometimes better to have a bit more time," she said, singling out Portugal, Spain, and Greece for slower fiscal adjustment. Lagarde's advice was based on an IMF working paper claiming that fiscal multipliers are greater in the short term than previously thought. But the paper was based on dubious forecasts of growth and considered only the ensuing year, disregarding other factors like access to capital markets.
Contrary to the IMF's position, countries in serious financial crisis have plenty of reasons to front-load stabilization programs. For example, many countries hit their borrowing ceilings suddenly and unexpectedly because of the inherent volatility of credit markets. The earlier sufficient fiscal adjustment is undertaken, the earlier confidence can be restored among citizens, businesses, governments, and foreign investors.
Early crisis resolution also breeds better reform programs that rely more heavily on expenditure cuts than tax hikes, since the latter are difficult to swallow during an economic crisis. Large expenditure cuts drive structural reforms, which in turn promote growth. Rapid crisis resolution, moreover, means a faster return to growth and, thanks to structural reforms, a higher trajectory of growth than would have otherwise been the case.
Early and radical adjustment may also be preferable from a political standpoint because people are prepared to make sacrifices when a crisis hits -- not many months (or years) after the fact, when they are tired and interest groups have had a chance to regroup. This April, Lagarde called "fatigue of both governments and population" the greatest risk to the eurozone: "What we're saying," she said, "is 'There's a bit more to do. Please don't give up now.'" But why did she tell them to slow down half a year earlier?
The empirical record is stunningly clear. The three Baltic countries -- Estonia, Latvia, and Lithuania -- suffered the most from the international liquidity freeze in the fall of 2008. All subsequently undertook front-loaded fiscal adjustment programs. By 2011 and 2012, they were Europe's fastest-growth countries, averaging around 5 percent growth annually. The Southern European crisis countries, by contrast, followed the IMF's advice to delay fiscal tightening. They have tried to raise more revenues instead of cutting expenditures and have carried out far milder structural reforms. As a result, their economies continue to suffer, and their populations are rightly upset over their governments' impotent response to the crisis.
TORU YAMANAKA/AFP/Getty Images
SUBJECTS:
