I recently came across Chapter 3 of the IMF World Economic Outlook of 2010 which examines the macroeconomic effects of fiscal consolidation, the recent favorite European sport. It seems that even the IMF has already made clear how ineffective austerity is in the current environment, especially in a monetary union such as the Eurozone where exchange rate devaluation and monetary stimulus are off the table:
(abstract from the IMF analysis)
The main findings of the chapter are as follows:
• Fiscal consolidation typically has a contractionary effect on output. A fiscal consolidation equal to 1 percent of GDP typically reduces GDP by about 0.5 percent within two years and raises the unemployment rate by about 0.3 percentage point. Domestic demand—consumption and investment—falls by about 1 percent.
• Reductions in interest rates usually support output during episodes of fiscal consolidation. Central banks offset some of the contractionary pressures by cutting policy interest rates, and longer-term rates also typically decline, cushioning the impact on consumption and investment. For each 1 percent of GDP of fiscal consolidation, interest rates usually fall by about 20 basis points after two years. The model simulations also imply that, if interest rates are near zero, the effects of fiscal consolidation are more costly in terms of lost output.
• A decline in the real value of the domestic currency typically plays an important cushioning role by spurring net exports and is usually due to nominal depreciation or currency devaluation. For each 1 percent of GDP of fiscal consolidation, the value of the currency usually falls by about 1.1 percent, and the contribution of net exports to GDP rises by about 0.5 percentage point. Because not all countries can increase net exports at the same time, this finding implies that fiscal contraction is likely to be more painful when many countries adjust at the same time.
• Fiscal contraction that relies on spending cuts tends to have smaller contractionary effects than tax-based adjustments. This is partly because central banks usually provide substantially more stimulus following a spending-based contraction than following a tax-based contraction. Monetary stimulus is particularly weak following indirect tax hikes (such as the value-added tax, VAT) that raise prices.
• Fiscal retrenchment in countries that face a higher perceived sovereign default risk tends to be less contractionary. However, even among such high-risk countries, expansionary effects are unusual.