Fiscal Adjustments: What Do We Know and What Are We Doing?

In the aftermath of the Great Recession, many OECD countries need to reduce large public-sector deficits and debts. The conventional wisdom about the political economy of fiscal adjustments goes more or less as follows. Deficit-reduction policies cause recessions. Voters do not like either spending cuts or tax increases, and they dislike the recessions associated with them. Therefore incumbent governments see fiscal adjustments as the kiss of death. They postpone them, and if they finally do implement adjustments, they will pay at the polls. In fact, many governments do the opposite: they try to increase deficits in order to win elections. Thus, we should expect fiscally “loose” governments to stay in office longer and fiscally prudent ones to be voted out of office.

If this view—which is a combination of textbook Keynesianism with “conventional” notions of naive voters’ behavior—were true, we would face a dark near-future. Governments would postpone the bitter medicine of fiscal adjustments, and when they eventually enacted tight fiscal policies, they would face both recessions and incumbent political losses. The result would be a sort of so-called “W” recovery along with the political turmoil created by the loss of fiscally responsible governments.

Fortunately, the accumulated evidence paints a different picture. First of all, not all fiscal adjustments cause recessions. Countries that have made spending adjustments to reduce their deficits have made large, credible, and decisive cuts. Even in the very short run, many reductions of budget deficits, even sharp ones, have been followed immediately by sustained growth rather than recessions. Second—and this is most likely a consequence of the first point—it is far from automatic that governments that have reduced deficits have routinely lost office. Governments that have initiated thorough and successful fiscal adjustment policies have not systematically suffered at the polls, especially when the electorate has perceived the urgency of a crisis or the possibility of defaulting on an external commitment. For instance, when several European countries had to tighten their fiscal belts to enter the European monetary union, many governments that successfully implemented fiscal adjustments were reelected.

Thus, according to recent evidence, there could be reasons to be less pessimistic than what the conventional wisdom sketched above would imply. However, the problem is that the wisdom is so conventional that it is often difficult to convince politicians and their economic advisors that this conventional wisdom may also be untrue. In addition, not all governments have the capacity and political will to overcome various impediments to fiscal adjustments. For instance, until recently, public employees in many European countries were able to secure wage increases larger than those in the private sector. Retirees and elderly workers, who often form a large part of labor unions, have resisted pension reforms. However, as we shall see below, this may be changing in several European countries. Thus, relatively painless (economically and politically) fiscal adjustments might be possible; whether governments will take the opportunity to make those adjustments remains to be seen.

Currently, several European governments have started, at least on paper, fiscal adjustment programs. Overall, my view of these efforts is relatively positive as the emphasis is much more on spending cuts than on tax increases. Political taboos, such as cutting public-sector salaries or health spending and raising retirement ages, are on the table. Also, supply-side reforms, such as tax decreases to stimulate the economies, are being considered.

Before moving forward, let’s be clear about what my argument regarding fiscal adjustment does and does not imply. I am not rejecting the “tax smoothing” theory of optimal fiscal policy (Barro 1979) at all. This theory argues that, because of the effect of automatic stabilizers, it is appropriate to allow deficits during recessions so long as during booms the deficit becomes a surplus and the deficit is, on average, zero during the cycle.¹ Thus it would be wrong to cut the deficits fighting against automatic stabilizers during recessions. This is not what I am arguing here. The point about fiscal adjustment is different. It says that when, for whatever reason, a discretionary policy of deficit reduction is needed, if it is done on the spending side, it has a good chance of not being recessionary. It has a much better chance of being expansionary and achieving a longlasting consolidation of the budget than an adjustment done on the tax side. (Note that, if an ideal tax-smoothing policy were followed and the budget were balanced over the cycle (with deficits in recessions and surpluses in booms), discretionary fiscal adjustments would never be necessary in theory. Of course reality is more complex than theory, and we have observed many examples of large deficits that would not be reabsorbed by automatic stabilizers without discretionary policy interventions.)

This paper is organized as follows: Section 2 discusses the evidence of the effects of fiscal adjustments on growth in the short run. Section 3 investigates the effects of fiscal adjustment on the popularity of governments and their prospects for reappointment. Section 4 discusses when and under what circumstances governments will initiate fiscal adjustments. Section 5 discusses the plans of several European governments for budget consolidations. Section 6 draws some implications of the previous discussion for U.S. policy makers. The last section concludes.

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¹ This holds under the assumption that no extraordinary temporary expenses need to be financed.