Greg Ip

Articles by The Economist’s U.S. Economics Editor

Austerity and the markets: The perils of prudence

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More evidence that austerity can backfire

Jan 28th 2012 | WASHINGTON, DC | from the print edition

[Greg Ip] THE fiscal hawks should be pleased. For all the hand-wringing about public profligacy, budget deficits across the rich world fell by about 1% of GDP last year. Moreover, that was almost all the result of policy actions (spending cuts and tax rises) rather than cyclical effects.Germany, France, Spain and Italy all managed to reduce their structural budget deficits, the latter three thanks to austerity. All are expected to reduce those deficits further this year, the International Monetary Fund said on January 24th. But this may not be good news. Austerity can unnerve markets, not calm them.The IMF studied the correlation between credit-default-swap spreads and a variety of economic indicators last year. Long-run indicators—for deficits, economic growth and spending on pensions and health care—had little impact on spreads. But larger near-term primary deficits (which exclude interest) were associated with notably wider spreads. So, too, was weaker current-year growth.This is surprising. In theory solvency should be a function of longer-term growth and fiscal trends, but markets instead seem to care more about the short term. Carlo Cottarelli and Laura Jaramillo of the IMF say tighter fiscal policy, by hurting the near-term growth outlook, could actually lead to wider, rather than narrower, spreads. Cut the deficit too aggressively, in other words, and the negative impact on growth and the rise in the cost of debt service from higher spreads could result in a higher, not lower, debt-to-GDP ratio.

Mr Cottarelli and Ms Jaramillo advise caution in interpreting these results: they may reflect circumstances unique to 2011. Their findings do not mean austerity should be avoided at all costs; but they do suggest it should be accompanied by steps to protect growth. And the study explains why the IMF is urging many countries with a choice not to press austerity further this year. “Decreasing debt is a marathon, not a sprint,” Olivier Blanchard, the fund’s chief economist, has observed. Pace yourselves.

The original article is linked here.

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Written by gregip

January 26, 2012 at 1:34 pm

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