The Speed Limit of Fiscal Consolidation

AUG 2011 Source: GLOBAL INVESTMENT RESEARCH

Large fiscal adjustments are required around the world, particularly in the advanced economies

  • The large fiscal adjustment needed around the world will require a delicate
    balancing act. Act too slowly and progress will be insufficient. Act too quickly
    and the economy may stumble.
     
  • Countries are more likely to achieve sustained adjustments when initial
    deficits are high and the adjustment focuses on spending cuts.
     
  • Consolidations are likely to act as a significant drag on growth regardless
    of whether they focuson cutting spending or raising taxes and particularly
    when not accompanied by monetary easing.
     
  • The extent of the growth drag will likely vary across countries, as adjustments
    tend to be more painful in large, closed economies and countries with
    fixed exchange rates.
     
  • The “speed limit” of fiscal adjustment—the pace of tightening after which
    the corrosive impact on growth starts to undermine the fiscal position itself—
    is therefore likely to be lower in large, closed economies (like the US or
    Japan) and in countries with fixed exchange rates (European periphery)
    than in small, open economies (UK).

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Sven Jari Stehn
Vice President, Global Investment Research
Jan Hatzius
Managing Director, Global Investment Research
Dominic Wilson
Managing Director, Global Investment Research
Stacy Carlson
Analyst, Global Investment Research
Many thanks to Kevin Daly, Ed McKelvey, Lasse Nielsen, Zach Pandl, Alec Phillips, Steve Strongin, and Andrew Tilton for helpful comments, and to Sherry Wu and Maria Acosta-Cruz for research and publishing assistance.
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