Unlike the period after the global financial crisis, we doubt that we will see a widespread trend of austerity to reduce public sector debt ratios. Nonetheless, austerity will still be undertaken in a few isolated cases, primarily in emerging markets. And in other countries, we may still see redistributive tax rises on the rich to fund higher health spending and support for the less well-off.
- Unlike the period after the global financial crisis, we doubt that we will see a widespread trend of austerity to reduce public sector debt ratios. Nonetheless, austerity will still be undertaken in a few isolated cases, primarily in emerging markets. And in other countries, we may still see redistributive tax rises on the rich to fund higher health spending and support for the less well-off.
- The term austerity is often used to refer to government spending cuts, but here we take it to mean any measures (i.e. tax rises as well as spending cuts) taken to reduce the structural budget deficit. And some have already started to fret about the prospect of tax rises and government spending cuts to pay for the big fiscal packages that governments have launched to see their countries through the coronavirus crisis. If that were to occur, austerity would cast a shadow over the recovery that should start to come through soon as lockdowns are eased. Still fresh in people’s minds is the experience of 2010 onwards, when government budgets, primarily in developed economies, were sharply squeezed. (See Chart 1.)
- However, we do not think that another widespread round of austerity is likely. First, it is not actually required in most countries. The coronavirus will result in a sharp one-off rise in government debt but, given the low level of interest rates, governments can generally tolerate this. (See here.) Admittedly, there is a risk that the crisis also results in permanently bigger deficits and a deterioration in the trajectory of the debt ratio. Indeed, the austerity after the financial crisis was designed to fill the black hole left in the public finances by a permanently lower level of tax revenues. But this might be avoided now if the virus does not inflict too much long-term damage on the economy’s supply potential. (We will be writing more on this soon.) Even if it does, low interest rates mean that there is scope for most countries to run modest primary deficits while still ensuring that debt as a share of GDP is falling.
- In any case, the second reason why austerity is unlikely is that governments now have more confidence than in the past that financial markets will tolerate higher debt burdens. The justification for past episodes of austerity, including the one after the financial crisis, was that the near-term pain is worth it to avoid a sharp rise in government bond yields and higher borrowing costs that would inflict even bigger damage to the economy further ahead. But the past few years have shown that bond markets are unperturbed by high levels of government debt and in some cases (including the US) even by rising trajectories of debt.
- Third the austerity seen after the financial crisis hardly went well. Those who advocated it talked of “expansionary contractions” and low fiscal multipliers (the impact a change in government policy has on the economy). But later research indicated that fiscal multipliers are high, especially if options for loosening monetary policy are limited. So although some countries, like the US, seemed to weather austerity well, others did not. This might be because they started austerity while their economies were still weak. Relatedly, cutting government spending as a share of GDP did not just mean real government spending still rising, but at a slower rate than GDP; sharp real cuts in spending were seen. (See Chart 2.)
Chart 1: Annual Change in Structural Budget Balance (% of GDP)
Chart 2: Real Government Spending (% Peak to Trough after the Global Financial Crisis)
Sources: IMF, Refinitiv, Capital Economics
- We cannot be sure what would have happened without austerity. Nonetheless, in many European countries, it generally had both a bigger adverse effect on GDP and a slower impact on the budget deficit than expected. It may even have been self-defeating in some countries, reducing real GDP growth to the point that the debt burden ended up higher than it would have been without austerity. Admittedly, the impact of austerity depends on the types of tax rises/spending cuts that are introduced and the circumstances at the time. Cuts in day-to-day spending would be less damaging to the economy’s supply potential than the cuts in public sector investment or incentive-blunting tax rises that formed part of the post-financial crisis austerity drive.
- However, we doubt that the ingredients for a “successful” fiscal tightening are now in place. For a start, there needs to be scope for monetary policy to loosen to compensate. But central banks’ toolboxes are depleted and there are question marks over the effectiveness of the weapons they do have left. Meanwhile, the domestic economic backdrop should be robust. But this seems unlikely as economies recover from their virus-related hit. And it is best if a country is undertaking austerity in isolation, as strong net exports can potentially help to offset the impact on demand. But all countries will see a sharp rise in their public sector debt. At the very least, all of this means that most countries are unlikely to even contemplate austerity before their economies are fully recovered, even if it becomes a possibility once growth is stronger.
- And fourth, there is likely to be considerable voter resistance to more spending cuts. This partly reflects the scars from the last bout of austerity. Indeed, the economic damage resulted in an anti-austerity wave that led to the fall of governments in Europe. In addition, the coronavirus crisis will lead to pressure for governments to spend more, not less. Not only will there be demands for significant increases in funding for health services, but governments may also come under pressure to convert some of the supposedly temporary measures to see economies through the coronavirus crisis into more permanent measures. And more generally, a legacy of the coronavirus could be an expanded role of the state and pressure for greater welfare spending.
- Accordingly, we do not think that we will see a global rush to fiscal consolidation once the virus has passed. That said, there are a couple of caveats. One, is that there will still be some isolated cases of austerity. This will occur in countries where public sector debt ratios are not sustainable and the costs of austerity are considered to be more palatable than those associated with the alternatives of default or inflating away the debt.
- Among emerging markets, this will include Brazil, Mexico and South Africa. And while debt levels in developed markets generally look sustainable, Italy and possibly Greece are exceptions. Italy might also come under renewed pressure from the EU to sort out its fiscal situation when the current suspension of EU fiscal rules ends. And some of the other euro-zone countries where the debt ratio is on a sustainable trajectory may nonetheless want to speed up the pace at which it falls from its high level, including Spain and Portugal. So these countries might be possible candidates for austerity – although given that Italy, Greece and Portugal already run primary budget surpluses, further fiscal stringency could run into political and public resistance.
- The other caveat is that none of this rules out widespread tax rises. Support seems to be building for a rise in taxes on the rich, given that the coronavirus has disproportionately affected lower-income households (in both monetary and non-monetary terms). Windfall taxes on companies that have benefited from the coronavirus (such as tech firms or food retailers) have also been mooted. But rather than using these tax rises to reduce the deficit (i.e. austerity), governments are more likely to use the money for other things, such as cutting taxes for poorer households and raising health spending.
- Finally, note that even without the drag of austerity, the economic recovery in many countries is likely to be slow-going. It could take years for demand to recover completely, as social distancing remains in place, confidence remains subdued and firms have to repay emergency loans. (See here.) While we expect to see a sharp rebound in global activity once coronavirus-related restrictions are eased, GDP in most economies will still be below its pre-crisis path even after two or three years. (See here.) That will be the case even without the prospect of austerity; needless to say, countries facing an additional drag from austerity are likely to be among those experiencing the slowest recoveries.
Vicky Redwood, Senior Economic Adviser, email@example.com