Don't Kid Yourselves about Fiscal Consolidation

Op-ed in Welt am Sonntag

November 6, 2005

It seems that no matter who joins Angela Merkel in the Cabinet, the first order of economic business will be fiscal consolidation. Fiscal tightening is not urgently needed on an economic basis because growing public debt is not preventing Germany from making enough investments and its long-term interest rates remain stable and low. Still, fiscal consolidation is probably useful as a signal of the new government's commitment to reform as well as a contribution to countercyclical fiscal discipline in Europe as the continental economies recover in 2006.

Fiscal consolidation, however, will not be pro-growth, at least not in the near-term. In fact, it will be contractionary. And its long-term impact on German growth will depend importantly on how the fiscal consolidation is structured-if it relies heavily on tax increases without reforming pension and social security benefits, it might actually harm growth in the long-term as much as it helps. No Germans should fool themselves with fantasies of following in the footsteps of Denmark's 1980s "expansionary consolidation" or the United States' "Rubinomics" of the 1990s. Germany's circumstances are fundamentally different and are not conducive to such virtuous cycles from deficit reduction.

Fiscal discipline contributes to growth when it meaningfully reduces interest rates and otherwise raises investment demand in a country. At the same time, fiscal discipline also decreases growth to the extent that it withdraws public sector demand and that withdrawal has impact on private-sector decisions. Small open economies, like Denmark or Ireland, are predisposed to come out ahead on net from fiscal contraction. On the one hand, they are capable of attracting capital inflows from abroad that can be sizable relative to their domestic economy-and their fiscal discipline can increase the credibility of their exchange rate and price stability commitments, and meaningfully reduce the risk to foreigners of investing there. On the other hand, because so much of their domestic demand "leaks" abroad into imports, the multiplier on any fiscal policy they undertake is small, and thus the growth impact of any fiscal contraction is relatively low.

Germany, as the largest economy in Europe and the third largest national economy in the world, faces the opposite situation. Capital flows, in or out, are small relative to the total annual investment in the German economy, so changes in the country's fiscal position cannot swing much more impact than domestic sentiment alone would. Germany is the bedrock of the euro, and can make it on its own monetary commitment if needed, so there is no currency risk to reduce by fiscal discipline. The multiplier on German fiscal policy is relatively high, given the size of the domestic economy, so the direct contractionary effect from fiscal tightening is higher as well. On net, Germany would come out behind where Denmark would come out ahead.

What about the United States experience? The United States is a large economy, and supposedly its boom of the 1990s was fuelled at least in part by fiscal consolidation. Here again, though, Germany is in a different situation. For fiscal discipline to be expansionary in a large economy, a multi-step cycle is needed: a reduction in deficits must significantly reduce interest rates; the reduction in interest rates must significantly stimulate investment and consumption; and domestic demand growth must lead to sufficiently higher tax revenues to keep interest rates down without the need for further fiscal contraction. Each step in the process requires flexibility and forward-looking behavior in the private-sector, attributes the US economy has (for all its other problems).

These are attributes that the German economy does not share, absent further structural reform. Credit market interest rates in Germany have not varied much with changes in the public deficits, whereas US rates vary greatly on projections of future deficits. Both investment and consumption are less interest sensitive in Germany than in the United States-while this may reflect a prudent reluctance to leverage as much as American businesses and households do, this also limits the growth response to interest rate changes. And tax receipts in Germany are less pro-cyclical than in the United States, in part because capital gains tend to be smaller and play a smaller role in the economy. At each step, Germany cannot and will not duplicate the forces that turned fiscal discipline into growth in the United States.

The final factor to recognize is that most expansionary fiscal consolidations have taken place against a background of monetary ease. A 2003 European Commission study found that more than half the time that developed economies saw growth rise following a fiscal contraction was when monetary policy was loosened simultaneously. Certainly, the Federal Reserve's expansionary monetary policy in the 1990s had as much to do with the US boom as fiscal discipline. Yet, the European Central Bank clearly is going to be tightening policy over the next year, whatever steps the new German government takes on fiscal discipline.

Chancellor-elect Merkel and her colleagues had better be prepared to see the coming weak recovery in Germany harmed rather than helped by their fiscal consolidation efforts. As a result, they should concentrate their fiscal reforms on those areas that would do the most to enhance growth over the long-term: reducing the Lohnnebenkosten (non-wage labor costs), raising the retirement age, cutting subsidies and tax loopholes that distort business decisions, and breaking the automatic indexation of pensions and benefits to wage growth (instead of inflation). Otherwise, they may burn up their political capital quickly with little to show for it.

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Adam S. Posen Senior Research Staff

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