Budget Cuts and Growth: Short-term Pain, Long-term Gain

Most advanced economies will have to make difficult budget cuts

Results tend to be painful in the short term

In the long term, reducing government debt is beneficial

Analysis in a chapter of the IMF’s latest World Economic Outlook shows that initially fiscal retrenchment typically has contractionary short-term effects on economic activity, with lower output and higher unemployment.

But it is likely to be beneficial over the longer term. “In particular, lower debt is likely to reduce real interest rates and the burden of interest payments, allowing for future cuts to distortionary taxes,” the authors say. By boosting private investment, this increases output in the long term.

Will it hurt?

In the chapter titled “Will It Hurt? Macroeconomic Effects of Fiscal Consolidation,” the authors find that within two years of cutting the budget deficit by 1 percent of GDP, domestic demand—consumption and investment—is about 1 percent lower, and the unemployment rate is about ⅓ percentage point higher. Because net exports––exports minus imports––tend to rise when budget deficits are cut, the overall impact on GDP is a decline of ½ percent.

A number of factors usually soften the short-term impact of fiscal consolidation. Using a new data set, the authors show that central banks usually cut interest rates and the currency falls in value. This helps cushion the impact on consumption and investment, and boosts exports.

Second, fiscal consolidation is less costly when markets are more concerned about fiscal sustainability. Third, consolidations based on spending cuts are less painful than those based on tax hikes. This is largely because central banks cut interest rates more after spending cuts.

Today’s environment

The findings suggest that in today’s environment...