Budgetary Austerity Can Help Trim Trade Deficits

IMF research finds fiscal consolidation has large and long-lasting effect on current account

If monetary stimulus scope is limited, external adjustment is just as large but more painful

When many countries consolidate at the same time, the current account adjustment is smaller

Many advanced economies need to reduce their budget deficit to restore fiscal sustainability. Emerging and developing economies are tightening to rebuild fiscal policy room and in some cases to restrain overheating pressures.

The IMF has examined the repercussions of budgetary cutbacks on external trade balances—finding that cutting the budget deficit can also improve a country’s current account balance. The research shows that a fiscal consolidation of 1 percent of GDP improves the current account by over a half percent of GDP within two years, with the improvement persisting into the medium term.

The current account improves because imports fall with weaker domestic consumption and investment, and exports rise with the currency depreciation that tends to follow fiscal tightening.

Two birds with one stone

“The link between fiscal and trade balances matters because for some economies that have both trade and budget deficits, policymakers are hoping to hit two birds with one stone—fiscal consolidation of the right magnitude may actually reduce both deficits,” said Abdul Abiad, who headed the IMF research team.

The research was released as part of a chapter in the IMF’s World Economic Outlook, which is published twice a year ahead of the institution’s Spring and Annual Meetings. Another chapter looks at how monetary policy should respond to swings in commodity prices, and advised central banks to focus on “underlying” inflation—that is inflation that excludes the effects of short-term movements...