New Economy Short Cut Re-live: Reducing Government Debt, But How?

Do austerity programs actually fulfill their purpose of reducing government debt? What seems to be a clear-cut issue for Finance Minister Lindner is anything but, according to a new report by the International Monetary Fund. For the latest World Economic Outlook, the economists at the International Monetary Fund evaluated a number of consolidation attempts around the world. And the results are anything but clear. The April issue of the World Economic Outlook states that, on average, fiscal consolidations have negligible effects on debt ratios – mainly due to negative growth effects.

We invited co-author and IMF economist Adrian Peralta-Alva to discuss this at the May edition of our New Economy Short Cut with Achim Truger from the German Council of Economic Experts and Philippa Sigl-Glöckner from Dezernat Zukunft.

In many countries across the globe, public debt is elevated due to pandemic emergency spending and weak economic growth. Against this backdrop, the third chapter in the recent World Economic Outlook examines policy options for reducing debt. In contrast to what the “expansionary austerity” hypothesis suggests, simply increasing the primary balance for a sustained period of time is not the most effective way for reducing the debt ratio (public debt relative to GDP) due to its harmful side-effects on GDP. The IMF analysis finds that, during the last forty years, fiscal consolidation has not significantly affected debt ratios in advanced economies. This is why, according to Adrian Peralta-Alva, a nuanced approach is required in order to reduce debt ratios in a sustainable manner.

The IMF Research Department Deputy Division Chief presented the report´s findings on the adequate timing & composition of successful fiscal consolidation. The empirical analysis shows that growth-enhancing policies play an important role for fiscal consolidation. The explanatory power of GDP growth in explaining the behavior of debt-to-GDP is twice as strong as fiscal consolidation. The report highlights that consolidation is more productive in good times, when fiscal multipliers are low. Consolidation is also more likely to reduce debt in periods of less financial tightening, in periods when the debt stock is already high, and when the private-credit-to-GDP ratio is low. Moreover, improving the primary balance is more likely to be growth-friendly if it involves cutting government expenditure, especially in areas of wasteful spending, rather than when it is done through increasing taxes.  

Achim Truger (German Council of Economic Experts) welcomed the new empirical analysis in the report and underlined its importance for the European debate on fiscal rules.

Philippa Sigl-Glöckner (Dezernat Zukunft) pointed out that, even under the Debt Sustainability Analysis measures in the EU Commission proposal, many European countries will have to run high surpluses for a long time. At the same time, countries require more fiscal space to steer their economies in the direction of climate neutrality. Current fiscal indicators do not account for the macroeconomic effects of the required emissions restriction. Therefore, she suggested thinking about new indicators for debt sustainability in times of the green transition such as an indicator for net-zero asset stocks, in an attempt to measure future economic sustainability beyond the debt ratio, which merely reflects on past debt in relation to economic output.