Austerity Won't Be That Good to You
Hopes to exit the present global crisis through expansionary fiscal consolidation policies are farfetched, Roberto Perotti (Department of Economics) explains in his recent working paper The "Austerity Myth": Gain without Pain?, which revisits the fiscal consolidations of Denmark and Ireland in the 1980s and Finland and Sweden in the 1990s.
Perotti doesn't drop the thesis that fiscal consolidation may be expansionary if implemented mainly by cutting government spending, but shows that in all the four cases discretionary fiscal consolidations have been smaller than estimated in the past and that the governments relied on tax increases to a much larger extent than previously thought. The expansion, moreover, was obtained thanks to transmission channels no longer available to our economies in current circumstances.
In different ways, the currencies of all the four countries were devalued in the preceding or in the first months of consolidation. Denmark and Ireland, in fact, devalued their currencies before pegging them to the European Monetary System, while Finland and Sweden floated them before implementing the consolidation, with the effect of a strong depreciation. In three out of four cases, such depreciation translated into an export-led expansion, while in Denmark the subsequent income policies which restrained wages and the decline in inflation and nominal interest rates boosted domestic demand. Now, Perotti writes, "a depreciation is not available to EMU members, except possibly vis à vis non-Euro members and an expansion based on exports is not available to the world as a whole".
"In all episodes", Perotti says, "interest rates declined quickly, also helped by wage moderation and by the nominal anchor (the exchange rate in the exchange rate based stabilizations, and the inflation targeting in the two episodes under a float)". And again, interest rates are extremely unlikely to drop in 2011.
Even the pivotal role played by income policies and wage moderation is seen by Perotti as a feature difficult to replicate today, and in any case they are probably only effective for a few years, as the Danish experience suggests.