Sunday, January 29, 2012

Fiscal Adjustment: Too Much of a Good Thing?

by Carlo Cottarelli


January 29, 2012

The IMF has argued for some time that the very high public debt ratios in many advanced economies should be brought down to safer levels through a gradual and steady process. Doing either too little or too much both involve risks: not enough fiscal adjustment could lead to a loss of market confidence and a fiscal crisis, potentially killing growth; but too much adjustment will hurt growth directly.

At times over the last couple of years we called on countries to step up the pace of adjustment when we thought they were moving too slowly.

Instead, in the current environment, I worry that some might be going too fast.

Risk to recovery

The latest update of the Fiscal Monitor shows that fiscal adjustment is proceeding pretty quickly in the advanced economies—on average the deficit is projected to fall by a total of 2 percentage points of GDP in 2011-12. The decline is even larger in the euro area—about 3 percentage points of GDP. In a reasonably good growth environment this pace of adjustment would be fine. But in the current weaker macroeconomic environment bringing deficits down this quickly could pose a risk for the economic recovery.

Some might argue that adjusting is like taking a bitter medicine, and that it’s always best to get it over with as quickly as possible. Aggressive fiscal adjustment will surely be rewarded by markets through lower interest rates, and any cost to growth is simply the price paid to ensure that fiscal credibility is won or maintained.


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