Exactly what it says on the tin
Over the last few months, particularly since June last year when the first major cracks started showing in IMF/EU led program of fiscal consolidation in Greece, there is an ongoing discussion around the failure of the program with a growing body of economists now having the evidence on technical level to present how by design and based on basic macro logic the program was destined to fail.
One of the most concise analysis can be found in the most unlikely of places. A publication of the Finance and Development department of the IMF, titled Painful Medicine, back in September 2011. In their research, Ball, Leigh and Loungani, present the impact of fiscal consolidation on incomes and unemployment. Leigh and Loungani are both with the IMF’s Research Department.
One would think that in the IMF they speak with each other and the extensive research is not only shared but at the same time applied where is required. In the case of Greece this particular research could not be more applicable.
The troika came to Athens back in May 2010 with a very specific mission, to bring the country’s finances into a sustainable path that would allow for control over the growing debt while at the same time the program ensured the financing of the running Greek budget deficits and most importantly the servicing of the existing debt for the duration that Athens was out of the markets and could not roll over or issue new debt. A typical case of fiscal consolidation.
The IMF’s publication summarises the key message right from the start. In spite of the need of medium term fiscal consolidation in developed economies, slamming on the brakes too quickly will hurt incomes and job prospects hence there is a need for the short and mid-term adverse effects on growth and jobs to be balanced. It further settles the argument of expansionary austerity, using a different methodology and thirty different historical cases of fiscal tightening, where the evidence suggests that fiscal consolidation cannot be expansionary and has a purely contractionary nature with direct impact on employment and incomes.
…the evidence from the past is clear: fiscal consolidations typically have the short-run effect of reducing incomes and raising unemployment. A fiscal consolidation of 1 percent of GDP reduces inflation-adjusted incomes by about 0.6 percent and raises the unemployment rate by almost 0.5 percentage point (see Chart 2) within two years, with some recovery thereafter. Spending by households and firms also declines, with little evidence of a handover from public to private sector demand.
In economists’ jargon, fiscal consolidations are contractionary, not expansionary. This conclusion reverses earlier suggestions in the literature that cutting the budget deficit can spur growth in the short-term.
The research further highlights that the impact of fiscal consolidation in the short-term can be even more severe if the central banks do not or cannot implement monetary stimulus policies to support investment and consumption through lower interest rates with an associated depreciation of the local currency to boost exports.
The reduction in incomes from fiscal consolidations is even larger if central banks do not or cannot blunt some of the pain through a monetary policy stimulus. The fall in interest rates associated with monetary stimulus supports investment and consumption, and the concomitant depreciation of the currency boosts net exports. Ireland in 1987 and Finland and Italy in 1992 are examples of countries that undertook fiscal consolidations, but where large depreciation of the currency helped provide a boost to net exports.
Further, simulations of the IMF’s models suggest that the impact of fiscal consolidation in the absence of stimulus from central banks and when consolidation is implemented simultaneously by many countries can have twice the impact suggesting a circa 1% reduction in incomes and employment for every 1% of GDP consolidation effort.
Additionally, the research concludes that the impact is less severe when the consolidation is achieved through spending cuts rather than tax hikes and, equally importantly, the IMF research does not find any evidence to prove the so-called confidence effect with no surge in consumption and investment as a result of the fiscal consolidation implementation.
Fiscal consolidation may also seem less painful when markets are more concerned about the risk of a government defaulting on its debt. This could reflect so-called confidence effects: the fact that the country is tackling the fiscal situation can impart confidence to financial markets and to consumers and firms, leading them to spend more. But the IMF research found that even in such cases, on average, the effects are contractionary, with no evidence of any surge of consumption and investment.
The impact of fiscal contraction is reflected in both short-term and long-term unemployment, however it is much greater on the long-term unemployed. As the research shows (graph below) the impact on short-term unemployment seems to be subsiding after a period of three years, unlike the impact on long-term unemployment that persists and leaves the economy with a more permanent structural unemployment damage.
…long spells of unemployment reduce the odds of being rehired. For instance, in the United States today, a
person unemployed for more than six months has only a 1 in 10 chance of being rehired in the next month, compared with 1 in 3 odds for a person unemployed less than a month. The increase in long-term unemployment thus carries the risk of entrenching unemployment as a structural problem because workers lose skills and become detached from the labor force—a phenomenon referred to as “hysteresis” (Blanchard and Summers, 1986).
A December 2011 publication of the IMF presents a more detailed analysis on the impact of unemployment and the actions that governments need to take to alleviate the effects of joblessness and its impact on people’s lives.
More striking is the inequity in the burden sharing of the fiscal consolidation with wage earners suffering a sharper, more extensive and persistent reduction in wages (graph below).
The IMF research concludes that a fiscal consolidation program requires realistic expectations about the impact on wage earners incomes and unemployment, particularly the structural one, the costs must be balanced against the long-term benefits, suggests measures that are adopted now but reduce deficits in the future when growth is more robust and, if you are from Greece or have been following the Greek crisis you will probably smile – or cry – reading this, fiscal consolidation programs should make provisions to adjust to slower growth than initially planned.
Fiscal consolidation plans should also spell out how policies would respond to shocks, such as slower growth than envisaged in the plan. For instance, plans could specify that unemployment benefits would be shielded from cuts in the event of slower growth than assumed in the plan. History shows that fiscal plans succeed when they permit “some flexibility while credibly preserving the medium-term consolidation objectives” (IMF, 2011; see also Mauro, 2011).
Now think Greece. The country was expected in the initial MoU to cut the government deficit from over 15% in 2009 to 3% in just two and half years. The troika’s initial projections were for a mild recession in 2011 of 2.6%, growth, that would have started in Q4 2011, of 1.1% for 2012, an unemployment rate of 14.6% for 2011 and 14.8% for 2012.
Add to the mix the emerging nature of the Greek economy – as opposed to the primarily developed economies used in the study - the completely defunct Greek public sector that was not prepared to implement the most ambitious reform program in the country’s history, the unwillingness of the Greek political elite to confront a system of their own creation over the last three decades, the country’s inability to respond with monetary measures, ECB holding firm on rates and actually increased in September 2011, the ongoing discussion about Greece’s potential exit from the euro that led to a bank run in the volume of EUR65bln since 2009 and the contraction of credit expansion, with Greek banks pretty much on life support, and the troika’s refusal to adjust targets in light of the deepening recession that added more tax hires and emergency taxation just to satisfy Greece’s new creditors.
It should come as no surprise that the Greek economy has shrunk by 10% since May 2010 when the program was introduced, with the most optimistic 2012 forecasts for a further 3%, or that unemployment is at 19.2% as released by Eurostat last week. The economy responded exactly as previous evidence suggests with the impact multiplied by a number of factors that only aggravated the situation.
The argument that the program in Greece did not work is ungrounded. The EU/IMF driven fiscal consolidation did to the Greek economy, incomes and unemployment exactly what it says on the tin.