De-Mythologizing Fiscal Consolidation

In Lost Decades, Jeffry Frieden and I argue that fiscal consolidation is a necessary prerequisite for long term recovery; however, fiscal consolidation too soon can derail the recovery, and plunge us further into debt. In contrast, some commentators have asserted that fiscal consolidation can be accomplished painlessly, or even with immediate benefits (e.g., JEC-Republicans, Rep. Paul Ryan/Heritage Foundation). Recent empirical work which carefully identifies the relevant episodes concludes that such instances of expansionary fiscal contraction are rare, and usually conducted near full employment. Ball, Leigh and Loungani review the effects of fiscal contraction in “Painful Medicine”.

…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.

The September 2010 WEO cross-country analysis of fiscal contraction effects was discussed in this post (And the absence of expansionary fiscal contraction in the UK here).

Fiscal contractions raise both short-term and long-term unemployment, as shown in Chart 3, but the impact is much greater on the latter. Long-term unemployment refers to spells of unemployment lasting more than six months. Moreover, within three years the rise in short-term unemployment due to fiscal consolidation comes to an end, but long-term unemployment remains higher even after five years.

So, in addition to contracting the economy, fiscal contractions exacerbate the already daunting challenges facing the long term unemployed (keeing in mind long term unemployment is not necessarily the same as structural unemployment). [1] [2]


What about how the burden of adjustment is allocated?

How does fiscal consolidation affect the distribution of income between wage-earners and others? The research shows the pain is not borne equally. Fiscal consolidation reduces the slice of the pie going to wage-earners. For every 1 percent of GDP of fiscal consolidation, inflation-adjusted wage income typically shrinks by 0.9 percent, while inflation-adjusted profit and rents fall by only 0.3 percent. Also, while the decline in wage income persists over time, the decline in profits and rents is short-lived (see Chart 4).

Chart 4 is reproduced below.

Source: Laurence Ball, Daniel Leigh, Prakash Loungani, “Painful Medicine,” Finance and Development 48(3) (September 2011).

The foregoing suggests that the schedule of fiscal consolidation should be such that spending cuts and tax increases are implemented when the economy has recovered. The findings also imply that fiscal consolidation should be accompanied by measures to protect low wage earners and the long term unemployed.


Hence, our fiscal policy prescriptions in Lost Decades:

…with the economy growing only modestly as recovery began,
too rapid a retrenchment in spending and an increase in taxes could
very well be counterproductive, throwing the economy back into
recession and further accumulation of debt. However, the politics of
countercyclical fiscal policy can be perverse, as the Obama administration
found. Recessions hit hardest at poor and working-class
families, who would benefit most from stimulative fiscal policy. But
attempts to undertake these policies face opposition from upperincome
taxpayers who are less affected by the recession and more
concerned about the impact on their future taxes. This opposition
can impede an effective fiscal response to cyclical downturns.
Whatever the difficulty with devising appropriate short-term
fiscal policy, government finances over the next two decades need everyone’s focused attention. The big problems are Americans’
unwillingness to tax themselves, ever since the Bush tax cuts of
2001 and 2003, and the entitlement programs—Medicare, Medicaid,
and Social Security—which are going to consume ever greater
shares of the budget.

Jeff Frieden and I will be online participating in the FireDogLake Book Salon this afternoon, 5-7PM Eastern, where we can answer some of your questions in near-real time. Mike Konczal of Rortybomb will be moderating.

10 thoughts on “De-Mythologizing Fiscal Consolidation

  1. 2slugbaits

    “inflation-adjusted profit and rents fall by only 0.3 percent”
    It’s worse than that. The impulse/response charts reflect one standard error bands, so it’s quite likely that profits and rents are not affected at all.
    But why is Menzie attending a talk when Nebraska is coming to Wisconsin for tonight’s game? Why isn’t Menzie at Camp Randall tonight? Professor, you need to get your priorities straight.

  2. Menzie Chinn

    2slugbaits: The game starts at 7pm Central, and we’ll be finished by 6pm Central (the online Book Salon runs from 5-7 Eastern), so … no worries! Football and political economy in one evening – what more can one ask for!

  3. Steven Kopits

    Right now, pro forma, we run into oil shocks every 3-4 years (four, per our model). From peak oil price (July 2008) to peak (April 2011) was less than three years this time around, and it occurred in the context of quite weak OECD economies. (From trough (Dec. 2008) to peak (April 2011) was 29 months, with a price differential of $80/barrel.)
    In this world, we don’t get a breather. How do you reconcile a continuous need to increase stimulus–increase the deficit–with an on-going series of short-cycle oil shocks?

  4. Olaf Storbeck

    Interesting post. An important related piece of research ist the book “Chipping away at public debt”, edited by Paulo Mauro (IMF).
    They did meticulous case studies of austerity plans and actual results in a number of developed countries. They came to the cnclusion that economic growth is the most important precondition for austerity programs to succeed. Higher tax revenues are also ,ore important than spending cuts.
    Iblogged about this a few days ago:

  5. Ricardo

    Can you tell us what you see as the difference between fiscal consolidation and fiscal contraction. It appears that you equate the two with austerity.

  6. Mezurak

    Look, you can play these word games until the cows come home. The average citizen is not going to accept reductions in SS and Medicare because they have PAID into those services. They feel they are not entitled to anything except the delivery of a service they paid for. The only consolidation they want to see is the gathering up of all the flimflam financiers into Cell Block C.

  7. acerimusdux

    “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”

    Translating that to the US economy it comes to $150B in fiscal contraction costing 750k jobs. But keep in mind this is just the average. For a struggling economy barely out of recession, with interest rates up against the zero lower bound, the effect is going to be larger, maybe twice that. I think at the current time, the $100k per job estimate is probably more accurate, thus 1.5M jobs.

    For those who wonder why we can’t simply return to Clinton era levels of spending and taxes, perhaps this helps provide an answer (unless one is a fan of 20% unemployment). The problem is that going back to 1998 fiscal policy isn’t going to produce 1998 asset prices.


    That’s a lot of lines in one graph, but the main point here is the tight correlation between the federal deficit, the output gap, unemployment, and asset prices (S&P500 and total net worth).

    Since I’ve expressed all of these (except unemployment) as a percentage of potential GDP, I guess the first obvious question is whether the common term is causing the correlation. It’s not. There is very little variance there:


    So clearly we are looking at a strong relationship between asset prices and GDP and budget deficits. It seems obvious to me the direction this relationship goes: falling asset prices lead to a wealth effect, reducing consumer demand, and at the same time lowering tax revenues.

    Brad DeLong recently observed “Second, bond investors are being really stupid. In a world in which the S&P 500 has a 7% annual earnings yield, nobody should be happy holding a US government 30-year inflation-adjusted bond that yields 1% per year.” Unfortunately, that doesn’t mean those markets will correct themselves any time soon. Markets have a history of going over very long periods of time from very overvalued to very undervalued. We are still not as undervalued as we have been at times in the past. Looking at the S&P 500 as percentage of potential GDP, for example:


    If the market goes where I think it’s going, and the political process goes where I think it’s going, I think we’re looking at 15-20% unemployment in the US in the not too distant future.

  8. Troy

    My analysis looks at the rents — ground and economic — the middle class is paying but not really getting back in the form of wages.
    $1T/yr in health care economic rents — our $7500 per capita cost is $3000 higher than global norms. On the plus side for the working class, health does have 14 million jobs, but those could be supported at a $4500 per capita cost with less rent-seeking going on.
    Then there’s the $500B/yr we spend on gasoline. That is a lot of money leaving the middle class never to return except as 0% balance transfer offers etc.
    $300B/yr trade deficit with China & Mexico. Six million jobs being sucked out of the country.
    $2T or so in ground rents being paid from working class to capitalist class that owns so much land.
    I don’t think economists understand the scale of flows here, from workers to capitalist.
    It is immense, and it’s my thesis that the $6T housing bubble of 2002-2006 gave us temporary respite via home equity withdrawal and FIRE sector employment (real estate sales, loans, rehab, etc).
    Now that the $1T/yr debt take-on is over for consumers, if government starts cutting back this whole thing is simply collapsing.
    interest never sleeps

  9. Matt

    RE: the above – no kidding. Why do you think they’re DOING IT? Squeezing every drop of income out of the wage-earner tube has been GOP SOP for decades, with the willing help of the gawd-gheyz-gunz segment of the squeezees..

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