Dubious monetary benefit from fiscal squeeze
Monday 18 December 1995
Conventional wisdom and economic theory suggest that the reward for fiscal squeeze is monetary ease and a fall in both short- and long-term interest rates. In the first instance, the monetary ease provides some support for economic activity to help offset the debilitating effects of the fiscal tightening. Later, the monetary ease provides a stimulus as the impact of the fiscal squeeze on activity fades and the economy feels the benefit of a lower structure of interest rates.
While the experience of the last few years confirms that there are up- front costs associated with fiscal consolidation, there is little evidence so far to support the view either that there is a monetary offset or an eventual boost to growth. While some G7 interest rates have fallen, the weighted average is little changed from its average in 1993.
In order to explore further the impact of a fiscal squeeze on the economic outlook we have analysed the monetary impact of a number of periods of successful fiscal consolidations over the last 20 years identified by Alesina and Perrotti in a recent study, 'Fiscal Expansions And Adjustments in OECD Countries' (Economic Policy 21, October 1995). The authors define a successful fiscal consolidation as a very tight fiscal stance in one year such that the gross debt/GDP ratio three years later is at least 5 percentage points of GDP lower than in the first year.
They identify 14 successful episodes spread across the OECD area between 1968 and 1990. Although the examples of successful fiscal consolidation are geographically diverse and spread throughout the period, they should provide a decent test of whether monetary ease follows fiscal squeeze.
Perhaps the most surprising finding is the rise in short-term interest rates following the period of fiscal consolidation. On average, three years after the initial tightening, short-term rates were 1.1 per cent higher, rather than the drop predicted by theory. Only four episodes saw a fall in short-term rates over three years: France in 1969, Denmark and Sweden in 1984 and the UK in 1969. Bond yields show a tendency to fall in the first year as the fiscal consolidation has its initial impact but this effect fades thereafter.
A number of important conclusions follow from this case study, which have direct implications for the economic outlook over the next couple of years:
o Virtually all successful fiscal consolidations to date have taken place in a period of robust economic growth when the economy is either well established in an expansionary phase or is close to the top of the cycle;
o Almost all consolidations have been followed by a slowing of economic activity rather than an acceleration;
o Historical precedent as opposed to economic theory gives little support to the view that the negative impact on economic activity from a successful fiscal consolidation is offset by the resulting impact on monetary policy. Perhaps the most extreme example is the UK in the late 1980s when interest rates moved in the opposite direction to some massive swings in the Budget deficit;
o The only clear-cut evidence of monetary impact comes at the long end. An economy would therefore have to be particularly sensitive to long rates, especially in real terms, and insensitive to the exchange rate to benefit from any sense of monetary stimulus.
The clear-cut inference of our study is that if the world continues with its current programme of fiscal consolidation, this will continue to constrain the pace of economic activity. Both the OECD and IMF estimate a discretionary fiscal tightening of around 0.5 per cent of GDP over the next couple of years, as Europe chases the Maastricht criteria and the US attempts to balance its budget. While the risk of recession is very slight, as the imbalances required to create the conditions for a contraction in spending are simply not in place, a monetary-led acceleration in activity looks distinctly unlikely. Recent cuts in rates are a policy response to slow growth rather than the rewards for successful fiscal consolidation.
If this recovery does proceed at a slower pace than the last two recoveries it will also help to keep inflation in check. Indeed, the slower pace of economic expansion may well help to explain why inflation has remained so low and why real wages have been so subdued. This latter factor may well provide a silver lining in an otherwise dull and cloudy outlook, which sees the world economy growing at close to trend for some considerable time. If real wages do remain subdued this will continue to facilitate a rise in the profit share of GDP, which over the very long run will help lift the investment rate and minimise the inflation damage from sustained economic expansion. This upswing is likely to be very long but it may be some time before it becomes very strong.
There are also some interesting conclusions for specific countries. In the US, for example, while the current economic background augurs well for fiscal consolidation and a balanced budget package, medium-term success depends on expansion continuing, while short-run implementation suggests a slowdown. This conundrum suggests that the ability of the US to deliver a balanced budget should be treated with some scepticism.
The message from our study is boldest for France, where the fiscal consolidation package seems doomed to failure on all grounds. The economy is not well established in the upswing and is very insensitive to shifts in interest rates. If the monetary response is not there, then growth will suffer unless, as we suspect, the French abandon franc fort in 1996 and allow the exchange rate to depreciate.
Keith Skeoch is chief economist at James Capel & Co.
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