ARGUMENTS about austerity have taken on an almost religious fervour. To some—such as Wolfgang Schäuble, Germany’s finance minister, or George Osborne, his British counterpart—tough fiscal policy is the cure for excessive debt; and any easing risks betraying a confidence-sapping loss of resolve. To others, today’s austerity is self-defeating. Trying to cut deficits when economies are weak will lead to stagnation, they say, and even bigger debt burdens.
Emotions run high and both sides treat evidence sloppily. Foes of austerity pounced on a recent analysis by the IMF, which suggested that the economic impact of fiscal tightening in Europe had been worse than expected. Austerity advocates immediately queried the Fund’s regressions
Yet it is wrong to caricature austerity as good or bad. Austerity has hurt growth more than its proponents expected. But for many countries it has been less avoidable than its critics acknowledge. In most places the question is not whether to cut deficits, but how to cut them wisely.
Start with the relationship between austerity and growth. The argument that budget cuts might boost growth, common two years ago, has been discredited. Austerity can be expansionary if it leads to a sharp drop in interest rates, but that is not the case today. Many countries are all cutting at once, even as many households try to reduce their debts. Nominal interest rates in many places are close to zero. Under these circumstances, budget cuts will damage demand more than usual.
However, this does not mean that the focus on fiscal consolidation was misguided. Many of the countries that have suffered the biggest budget squeezes, particularly in the euro zone’s periphery, had no choice. Investors were shunning their bonds, and their European rescuers were unwilling to cough up more funds. Other countries, such as Britain, with gaping structural deficits reasonably feared a similar fate. The fact that bond yields are now at historic lows does not mean it was foolish to chart a course towards balancing budgets.
What matters is how austerity is imposed and what other policies accompany it. The experience of the past couple of years argues against sudden sharp cuts, and especially against tightening more when the economy turns out weaker than expected. Better to have a medium-term plan which gradually reduces underlying deficits. As for other policies, the main lesson is that austerity hurts more if it is not accompanied by bold monetary loosening. It has hurt the most in the euro zone’s periphery, where cuts were heavy and hurried and the European Central Bank (ECB) did little to counter them.
A surplus of enthusiasm
Happily, despite Mr Schäuble’s macho rhetoric, the pace of tightening in the euro zone is slowing. On current plans there will be budget cuts equivalent to about 1% of GDP in 2013, less than this year. Politicians are focusing more on structural deficit figures than headline ones. They are giving the wobbliest economies, such as Greece and Portugal, more time. It is not yet enough. Portugal’s budget is still too harsh; Spain’s targets are implausible (see article) and the ECB should loosen more. But euro-zone fiscal policy is heading the right way.
The main risks are now elsewhere. In Britain Mr Osborne still clings to a misguided target: that Britain’s ratio of debt to GDP should be falling by 2015. That would require doubling down on austerity. In America an even bigger mess threatens. A “fiscal cliff” of sudden, severe tax increases and spending cuts looms at the end of this year. Unless Congress acts America will plunge into recession. To avoid such woes, the world needs fiscal policy driven not by faith, but by reason.
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