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Fiscal consolidation and recovery from financial crisis

    Two diverging paths lie before the ministers and they may only travel one. One pointed to fiscal stimulus and the other to fiscal consolidation. This is a contemporary issue that has often gripped the political debate. Post the 2008 financial crisis, many countries have been burdened with problems of mounting debts. Letting the malaise become permanent by doing nothing is simply not an option. 

    A lot of countries have adopted a fiscal consolidation policy in response to the massive debt accumulated during the financial crisis, with the Republic of Ireland stands out as the “poster child”. Bolstered by strong growth and low unemployment, Ireland currently is on course to be the fastest-growing economy in the eurozone for the fourth straight year. Some critics of Ireland’s austerity programme claimed the fiscal consolidation programme impaired the economy’s ability to grow post-crisis and when the economy proceeded to grow spectacularly in Ireland, they then dismissed fiscal consolidation as an explanation and suggested it must be down to other means. 

    Indeed, it is possible other factors contributed to Ireland’s recovery. With a corporate tax rate of 12.5%, Ireland is often branded a “tax haven” as it has the lowest tax rate among all the developed countries. In recent years, more than 700 US multinational companies including Intel, Google, Facebook and Apple have decided to set up their headquarters in Ireland. These companies have brought with them foreign direct investment, jobs for the local economy, and tax revenues for the government. Ireland, as a member state of the European Union bordering the UK, seems to be well-placed to serve as a hub for international firms to access European markets and for domestic firms to export to the UK and the USA.

    However, it may be unfair to completely dismiss Ireland’s fiscal consolidation policy when explaining its recovery. What is interesting is that Ireland had been pursuing austerity on its own before implementing further cuts under the EC-IMF-ECB (Troika) loan programme. When many other countries were justifying the adoption of a fiscal stimulus programme when the crisis began to spread, Ireland decided to embrace austerity. This willingness of the Irish government to take unpopular decisions during that critical period calmed the bond market and broke the emergent linkage that had become apparent between the evaluation of Ireland’s and Greece’s fiscal prospects. As a result, Ireland’s ratings stabilised and it faced lower borrowing costs at that time. If Ireland had engaged in fiscal stimulus at that time, the opposite would probably have occurred. The already high level of national debt would have further increased, which would have negatively affected the level of foreign investment which was crucial for the recovery. It may have also faced higher borrowing costs due to increased perceived default risk.

    As the crisis progressed and the fiscal consolidation programme took effect in Ireland, the short-term reduction in domestic consumption and investment in the country was offset by increased foreign investment. And the recovery from then went from strength to strength. However, critics of Ireland’s austerity policy also claimed that the same had not worked in Greece. Undeniably, the favourable business-friendly environment in Ireland facilitated the Foreign Direct Investment-led recovery.  Greece, however, is a different case because its domestic situation was not attractive to investors even before the crisis happened.

    As the decision to repay the debt cannot be postponed indefinitely, it is better to reduce it when a country’s economy is not in a crisis. Governments can bring back fiscal stimulus in the future if they see fit, perhaps when the debt is on a sustainable footing. A fiscal stimulus policy that further increases the level of debt immediately post-crisis, in contrast, will commit the country to paying higher debt interest payments moving forward, which will impose financial constraints on the government’s ability to provide crucial services in the future. No one, not even economists, can accurately predict whether the interest will move unfavourably or when the next crisis will hit; therefore, reducing debt in the good times will be a prudent way of preparing an economy to weather any upcoming crisis. From the case of Ireland, fiscal consolidation helps stabilise the economy before the amount of debt grows out of proportion. Only when the economy has recovered and the deficit has fallen below 3% will the Irish government have the fiscal space to pursue an expansionary fiscal policy.

    However, a fiscal consolidation policy need not be imposed rapidly through an immediate cutback. Thoughtful planning before execution is crucial. Countries have significant discretion in how they can consolidate, either through tax increases or cutting spending or a combination of both. Any fiscal consolidation policy that a government undertakes should aim to cause the least harm to the citizens and the economy, and the redistributive consequences of the action have to be thought through and the reasoning clearly explained to the public. When being questioned on it, the ministers should be able to stand up and justify the necessity of the policy.  In addition, a suitable pace can be followed by individual countries through a planned fiscal consolidation timeline that fits the structure of the economy. In the case of the UK, the government sets the year it expects to balance the books, and adjusts it when shocks like Brexit affect the economy.

    Even John Maynard Keynes, the famous British economist who advocated expansionary fiscal policy, once said that governments should cut back in boom times. As national economies throughout the world are recovering from the previous crisis, it is important for national governments to try to reduce the mounting debt level in order to provide more room for manoeuvre when the next crisis hits.

     

    DISCLAIMER: The views set out in CPS blog posts are those of the individual authors only and should not be taken to represent a corporate view of the Centre for Policy Studies.

    Jun Yuan Ng

    Jun Yuan Ng is a CPS Summer 2017 economic research intern. Originally from Malaysia, he studied at Manchester University, graduating in 2017 with a degree in accountancy.

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