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Germany’s fiscal adjustment of 2004–2007 provides a good example. First, the country implemented a stimulus by reducing income tax rates. This reduction was part of a series of supply-side-oriented reforms implemented between 1999 and 2005, including a wide-ranging overhaul of the income tax system that was meant to boost potential growth but that did not have much effect until 2004. In addition, significant structural reforms to tackle rigidity in the labor market were put in place, as well as changes to the pension system to relieve demographic pressures. These reforms included “an increase in the statutory retirement age, the elimination of early retirement clauses, and tighter rules for calculating imputed pension contributions.” Finally, Germany adopted large expenditure cuts to the fringe benefits in public administration (such as ending Christmas-related extra payments) and also serious reductions in subsidies for specific industries, including residential construction, coal mining, and agriculture.
Sweden provides another example of successful adjustment. The data show that after the recession Sweden’s finance minister, Anders Borg, not only successfully implemented reduction in welfare spending but also pursued economic stimulus through a permanent reduction in the country’s taxes, including a 20-point reduction to the top marginal income tax rate. At the same time, Sweden benefited from a very aggressive monetary policy followed by strong export revenues and firm domestic demand. The country’s economy is now the fastest-growing in Europe, with real GDP growth of 5.6 percent, which has helped the country to rapidly shrink its debt as a percentage of GDP over the past decade.
The Swedish example raises the question of the appropriate role of monetary policy in successful fiscal adjustments. For instance, there is some evidence that at times exchange rate devaluation (induced by an accommodating monetary policy) can help to boost a country’s exports as the country becomes more competitive and, as a result, can compensate for a previous slowdown in domestic demand.
Economist Scott Sumner has made the case that the best way to get austerity and growth simultaneously is to increase “[nominal] GDP and budget surpluses—the Swedish way.” To be sure, monetary policy in Europe—or in the United States, for that matter—could increase the effectiveness of spending cuts and structural reforms (a little like the water you drink to help the medicine to go down). But it is a mistake to oversell it, and it certainly will not achieve our long-term goals without serious reductions in government spending. In particular, the devaluation of a country’s currency is neither a necessary nor sufficient condition for success, as shown by Alesina and Ardagna.
There is growing evidence, however, that private investment tends to react more positively to spending-based adjustments. The data from Alesina and Ardagna, and Alesina, Favero, and Giavazzi, for instance, show that private-sector capital accumulation increases after governments cut spending, which compensates for the reduction in aggregate demand due to the fiscal adjustments.
The good news is that it is possible to design a fiscal adjustment that could both reduce the deficit and have a minimal or even, in some cases, positive impact on the economy. It requires austerity based mostly on spending cuts. This can be accomplished without hurting the least advantaged in society. As Alesina wrote in November 2012,
But if we cut spending, do we necessarily hurt the poor? Not in such countries as Greece, Portugal, Spain, and Italy, whose public sectors are so inefficient and wasteful that they can certainly spend less without affecting basic services. Even in countries with better-functioning public sectors— such as France, where public spending is nearly 60 percent of GDP—there’s a lot of room to economize without hurting the poorest and most vulnerable. And even in America, public spending is about 43 percent of GDP, a level common in Europe not long ago, and up from 34 percent in 2000.
In other words, Western governments can save money and avoid inflicting injury on lower-income earners or the poor by improving the way welfare programs are targeted; scaling back programs such as Medicare that use taxes raised in part from the middle class to give public services right back to the middle class; and gradually raising the retirement age to 70. The same holds true for Social Security. What is more, lots of savings could be achieved by cutting subsidies going to businesses—which are often large, well-established, and politically connected firms, such as gas and oil companies, farms, automobile manufacturers, and banks.
Economists disagree a lot when it comes to fiscal policy. For instance, there is no consensus about the size of the spending multiplier or where on the Laffer curve most countries are situated. However, a consensus seems to have emerged recently that spending-based fiscal adjustments are not only more likely to reduce the debt-to-GDP ratio than tax-based ones but also less likely to trigger a recession. In fact, if accompanied by the right type of policies (especially changes to public employees’ pay and public pension reforms), spending-based adjustments can actually be associated with economic growth.
Fortunately, successful fiscal adjustments are possible when based mostly on spending cuts and accompanied by policies that increase competiveness, as we have seen in the case of Germany, Finland, and other more recent examples, such as Estonia and Sweden. However, it is important to refrain from oversimplifying these results since fiscal adjustment packages are often complex and multiyear affairs. Also, many of the successful (i.e., expansionary and debt-to-GDP-reducing) fiscal adjustments in this literature are ones where the growth is export-led during times when the rest of the global economy is healthy or even booming. While there has been some recovery in the midst of the recession, we should recognize that it may be much harder today to achieve export-led growth when many countries are struggling.
The cost of well-designed adjustments plans will not be zero, but will be relatively low. Besides, it is not clear that the alternative to reducing spending is more economic growth. In fact, the alternative for certain countries could be a very messy debt crisis.
For full endnotes and other documentation, read the testimony as a PDF.