Fiscal Consolidation is a Growth Strategy

Senior Fellow, RIETI

The government of Prime Minister Shinzo Abe has defined monetary policy, fiscal policy, and growth strategies as the "three arrows" of its economic policy. Indeed, the last two arrows—fiscal policy and growth—are in essence linked with each other. What is referred to here, however, is different from the standard Keynesian effect of fiscal policy where fiscal spending, typically in the form of public works projects, is to give a boost to economic growth. To the contrary, recent research findings suggest that fiscal consolidation may lead to a recovery in the economic growth rate.

The Japanese economy has been suffering from low growth since the 1990s in a phenomenon referred to as the "lost two decades." Sluggish productivity growth has been cited as a culprit for the prolonged stagnation, but the reason why productivity growth remains low has not been explained.

The first half of the lost two decades, or the 1990s, was plagued with non-performing loan problems, whereas the second decade, or the 2000s, saw an acceleration of population aging and a decline in the working-age population. While each of those factors potentially undermines economic growth, ballooning public debt has consistently haunted the Japanese economy throughout the two decades. Indeed, a series of recent empirical findings provide evidence supporting the concept of public debt overhangs, which argues that the presence of huge public debt is the primary factor hindering economic growth.

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In their 2012 paper, Public Debt Overhangs: Advanced-Economy Episodes Since 1800, Harvard University Professors Carmen M. Reinhart and Kenneth S. Rogoff and Vincent R. Reinhart, an economist at Morgan Stanley, examined 26 public debt overhang episodes in advanced economies and found that 23 of them coincided with long-term low economic growth. They also showed that annual economic growth rates are 1.2 percentage points lower on average in periods when the ratio of public debt to gross domestic product (GDP) exceeds 90% than in periods with the ratio below that level. Since such association between public debt and low economic growth is observable only when the public debt-to-GDP ratio is above 90%, Professor Reinhart et al. argue that a cumulative increase in public debt is what causes lower economic growth. In other words, public debt is not a problem so long as it remains small in size but suddenly inhibits growth when its ratio to GDP crosses the threshold of 90%.

Similar facts have been shown in data from the euro area. In their papers published in 2012 and 2013, Cristina Checherita-Westphal and Philipp Rother of the European Central Bank (ECB) et al. examined the relationship between public debt and economic growth, using data from 12 euro area countries over the past four decades. It was found that an increase in public debt has no significant impact or positive effects on economic growth when the initial debt level is low but works to reduce economic growth when the initial debt level is above 90%-100% of GDP. High-level public debt affects economic growth through such channels as decreased private sector savings, reduced public-sector investments, and lower productivity.

Just for the record, not until recently was it confirmed empirically that public debt can have a negative impact on economic growth. The enhancement of data in recent years, which made cases of high-debt countries available for analysis, has led to the discovery of such facts.

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Why does a cumulative increase in public debt inhibit economic growth? A textbook answer would be crowding out (see the Keywords section). Indeed, if the government continues its profligate spending and wasteful use of financial and other resources, leaving the private sector with insufficient resources, the rate of economic growth would decrease.

This sounds convincing because a cumulative increase in public debt can be taken as an indicator of fiscal profligacy. However, data suggest otherwise. Real interest rates should rise when crowding out occurs, but Professor Reinhart et al. found that real interest rates fell or remained unchanged in 11 of the 26 high-debt episodes examined (see the Figure). At the very least, the ongoing stagnation in Japan cannot be explained by crowing out as real interest rates have been stable over the past 20 years at a level lower than that of the previously observed one.

Figure: Growth and real interest rate outcomes for 26 high-debt episodes in advanced economiesFigure: Growth and real interest rate outcomes for 26 high-debt episodes in advanced economies
Source: Reinhart et al.

Another possible explanation is non-Keynesian effects (see the Keywords section). According to a 1999 paper by Bocconi University Professor Roberto Perotti, the working of non-Keynesian effects is as follows. Fiscal deterioration resulting from an increase in fiscal spending and/or tax cuts at the present time gives rise to the expectation that fiscal consolidation in the future will be extremely painful. This prompts consumers to save more and spend less at the present time in preparation for the future. Thus, non-Keynesian effects emerge where an increase in public debt leads to a decrease in consumption. However, this is essentially a theory for a short-term phenomenon, not meant to explain a long-term phenomenon such as persistent low economic growth of over 10 to 20 years.

While various theories—including University of Toulouse Professor Gilles Saint-Paul's endogenous growth model which shows that public debt necessarily reduces the growth rate—have been advocated, it is extremely difficult to explain the following two phenomena at the same time: 1) public debt above a threshold level causes long-term low economic growth, and 2) low economic growth caused by public debt may not necessarily be accompanied by a rise in interest rates.

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In order to explain these two phenomena faced by the Japanese economy, not only market movements but also politico-economic factors need to be taken into consideration. Assuming that "political and economic failure," as defined by Professor Daron Acemoglu of the Massachusetts Institute of Technology (MIT) and Professor James Robinson of Harvard University, had been occurring in Japan would explain both phenomena and help us to plan future policies.

Political and economic failure in this particular case is a commitment problem on the part of the government, i.e., a situation where the government becomes unable to promise certain types of policies when faced with the growing possibility of a change of government triggered by fiscal collapse. A high public debt ratio means that the debt cannot be sustained by ordinary austerity measures alone. Sooner or later, the government will have to take radical fiscal consolidation measures such as drastic tax hikes. This will lead to a change of government as such measures bring significant pain to the general public.

The incumbent government is inclined to postpone radical fiscal reform because its top priority is to maintain power. This, however, undermines the credibility of its commitment to long-term economic growth measures. For instance, achieving such policy goals as creating an environment that fosters new businesses and enhancing public education would require strategic spending over a long-time horizon, rather than pork-barrel spending on a single fiscal year basis.

However, since long-term expenditures increase the risk of fiscal collapse, people would not believe the government's promise to implement such measures. The government, for its part, would become unable to advocate policies requiring a long-term financial commitment because of this risk, which may accelerate a change of government, and/or out of the fear of being criticized for breaking its campaign promises.

The government's failure to present a credible long-term growth strategy creates greater uncertainty over corporate earnings prospects, thereby discouraging companies from developing new technologies and moving into new fields of business and hence resulting in lower economic growth. As companies cling to their existing technologies and business, productivity growth would slow down and real interest rates would not rise. Such situation would continue so long as the government continues to postpone fiscal reform.

Such political and economic failure is induced by the political motive or desire to postpone radical fiscal reform. A breakthrough to this situation can be made by breaking free from such political motive and implementing sweeping fiscal reform quickly. This would restore people's confidence in the government and brighten up prospects for businesses, thereby inducing the development of new technologies and the expansion of new fields of business and resulting in higher economic growth.

While the validity of the above theoretical hypothesis is subject to further examination, recent data has shown fairly conclusively that fiscal deterioration beyond a certain threshold works to reduce economic growth. This implies that fiscal reform per se can be a growth strategy.

>> Original text in Japanese

* Translated by RIETI.


  • [Crowding out]
    Increased government spending on public work projects and consumption often inhibit private sector economic activities by using up financial, human, and other resources. This phenomenon is referred to as "crowding out effect." In particular, in cases where such expenditures are financed by issuing government bonds, their market prices would fall (i.e., their market interest rates would rise), whereby increased government spending leads to a decrease in private sector investments and consumption through the channel of higher market interest rates.
  • [Non-Keynesian effects]
    A 1990 study conducted by Professor Francesco Giavazzi of Bocconi University and Professor Marco Pagano of the University of Naples Federico II found that fiscal consolidation resulted in an increase in private sector consumption in Denmark and Ireland. This finding is contradictory to Keynesian economic theory, which predicts that fiscal contraction should lead to a decrease in private sector consumption, and thus is called "non-Keynesian effects."

February 18, 2013 Nihon Keizai Shimbun

May 9, 2013

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