This article first appeared in Forum, The Edge Malaysia Weekly, on June 6 - 12, 2016.

The debt crisis in Europe continues to drag on. Drastic measures to cut government debts and deficits, including replacing democratically elected governments with “technocrats”, have only made things worse.

The more recent drastic expenditure cuts in Europe to quickly reduce public finance deficits not only have adversely impacted the lives of millions as unemployment soared but also seem to have killed the goose that lays the golden eggs (economic growth), resulting in a “low growth” debt trap.

Government debt in the eurozone reached nearly 92% of gross domestic product (GDP) at the end of 2014, the highest level since the single currency was introduced in 1999. It dropped marginally to 90.7% at the end of last year, but is still about 50% higher than the maximum allowed level of 60% set by the Stability and Growth Pact to ensure that European Union members “pursue sound public finances and coordinate their fiscal policies”. The debt-GDP ratio was 66% in 2007 before the crisis.

High debt is, of course, of concern. But as the experiences of the EU nations clearly demonstrate, countries cannot come out of debt through drastic cuts in spending, especially when global economic growth remains tepid and there is no scope for a rapid rise in export demand. Instead, drastic public expenditure cuts can jeopardise growth, creating a vicious circle of low growth and high debt, as noted by the International Monetary Fund (IMF) in its October 2015 World Economic Outlook.

Deficit, debt and fiscal consolidation

Using historical data, a number of cross-country studies claimed that fiscal consolidation promotes growth and generates employment. Three of them have been the most influential among policymakers dealing with the economic crisis unleashed by the 2008-09 global financial meltdown.

First, using data from advanced and emerging economies for 1970-2007, the IMF’s May 2010 Fiscal Monitor claimed a negative relationship between initial government debt and subsequent per capita GDP growth as a stylised fact. On average, a 10 percentage point increase in the initial debt-GDP ratio was associated with a drop in annual real per capita GDP growth of around 0.2 percentage points per year.

By implication, a reduction in debt-GDP ratio should enhance growth. Released just before the G20 Toronto summit, it provided the ammunition for fiscal hawks calling for immediate fiscal consolidation. The IMF has since admitted that its fiscal consolidation advice in 2010 was based on an ad hoc exercise.

Using a different methodology, the IMF’s 2010 World Economic Outlook reported that reducing fiscal deficits by 1% of GDP “typically reduces GDP by about 0.5% within two years and raises the unemployment rate by about 0.3 percentage point. Domestic demand — consumption and investment — falls by about 1%”.

Similarly, a 2015 IMF research paper concluded that “empirical evidence suggests that the level at which the debt-GDP ratio starts to harm long-run growth is likely to vary with the level of economic development and to depend on other factors such as the investor base”.

The second study — of 107 episodes of fiscal consolidation in all Organisation for Economic Co-operation and Development countries between 1970 and 2007, by Alberto Alesina and Silvia Ardagna —  found 26 cases associated with resumed growth and probably influenced policymakers most. This happened despite the actual findings showing that “sometimes, not always, some fiscal adjustments based on spending cuts are not associated with economic downturns”.

Yet, in Harvard professor Alesina’s public statement, “several” became “many”, “sometimes” became “frequently” and mere “association” implied “causation”. In April 2010, he told EU economic and finance ministers that “large, credible and decisive” spending cuts to rescue budget deficits had frequently been followed by economic growth. He was even cited in the official communiqué of an EU finance ministers’ meeting.

Jonathan Portes of the UK Treasury has acknowledged that Alesina was particularly influential when the UK Treasury argued in its 2010 “Emergency Budget” that the wider effects of fiscal consolidation “will tend to boost demand growth, could improve the underlying performance of the economy and could even be sufficiently strong to outweigh the negative effects”. Christina Romer, then chair of the US President’s Council of Economic Advisers, also acknowledged that the paper became “very influential”, noting exasperatedly that “everyone has been citing it”.

Researchers have found serious methodological and data errors in this work. Historical experience, including that of current eurozone economies, suggests that the probability of successful fiscal consolidation is low. These successes depended on factors such as global business cycles, monetary policy, exchange rate policy and structural reforms.

Drawing on the IMF’s critique of Alesina and his associates, even the influential The Economist (September 30, 2010) dismissed the view that fiscal consolidation today would be “painless” as “wishful thinking”. Nevertheless, the IMF’s policy advice remained primarily in favour of fiscal consolidation regardless of a country’s economic circumstances or development level. There seems to be a clear disconnect between the IMF’s research and its operations.

The third study, by Harvard professors Carmen Reinhart and Kenneth Rogoff on the history of financial crises and their aftermaths, claimed that rising government debts are associated with much weaker economic growth, indeed negative rates. According to them, once the debt-to-GDP ratio exceeded the threshold ratio of 90%, average growth dropped from around 3% to -0.1% in the post-World War II sample period.

Since then, however, significant data omissions, questionable weighting methods and elementary coding errors in their original work have been uncovered. Nevertheless, the Reinhart-Rogoff findings were seized upon by the media and politicians around the world to justify austerity policies and drastic public spending cuts.

Bill Clinton, fiscal hawk?

Supporters of austerity-based fiscal consolidation often cite President Bill Clinton’s second term in the late 1990s. However, the data shows that fiscal consolidation was achieved through growth, contrary to the claim that austerity produced growth.

Clinton broke with the traditional policy of using the exchange rate to address current account or trade imbalances, opting for a strong US dollar. Thus, the greenback rose against major currencies from less than 80 in January 1995 to over 100 by January 2000.

The strong US dollar lowered imported inflation, allowing the Federal Reserve to maintain low interest rates even though unemployment fell markedly. The low interest rate policy not only boosted growth but also helped keep bond yields close to the nominal GDP growth rates. Thus, the interest burden was kept under control, with primary balances stable at close to zero.

Anis Chowdhury was professor of economics, University of Western Sydney, and has held various senior United Nations positions in New York and Bangkok. Jomo Kwame Sundaram was UN assistant secretary-general for economic development. This is the second of a three-article series on the economic thinking responsible for the protracted global economic slowdown.

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