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Fiscal consolidation increases inequality, harms growth

Published:Wednesday | June 8, 2016 | 12:00 AMMcPherse Thompson
The International Monetary Fund headquarters in Washington, DC.

Fiscal consolida-tion, one of the linchpins of Jamaica's current programme with the International Monetary Fund (IMF), has, on average, been followed by drops in growth rather than expansion, according to a new study by officials at the Fund.

Fiscal consolidation is a policy aimed at reducing government deficits and debt accumulation.

However, on average, a consolidation of one per cent of gross domestic product (GDP) increases the long-term unemployment rate by 0.6 percentage point and raises by 1.5 per cent, within five years, the Gini measure of income inequality, said the study undertaken by Jonathan D. Ostry, deputy director; Prakash Loungani, division chief; and Davide Furceri, an economist, all in the IMF's Research Department.


Writing for the June 2016 issue of the IMF's quarterly magazine, Finance & Development, under the theme 'Neo-liberalism: Oversold?', the researchers suggested that instead of delivering growth, some neo-liberal policies have increased inequality, and in turn, has jeopardised long-lasting expansion.

The term 'neo-liberalism' has been used since the 1950s in reference to the resurgence of 19th-century ideas associated with laissez-faire economic liberalism. Its advocates support extensive economic liberalisation policies such as privatisation, fiscal austerity, deregulation, free trade, and reductions in government spending in order to enhance the role of the private sector in the economy.

The researchers suggest that there is much to cheer in the neo-liberal agenda, noting, among other things, that the expansion of global trade has rescued millions from poverty and that privatisation of state-owned enterprises has, in many instances, led to more efficient provision of services and lowered the fiscal burden on governments.

"However, there are aspects of the neo-liberal agenda that have not delivered as expected," they said.

The researchers confined their assessment to the effects of two policies - removing restrictions on the movement of capital across a country's border, and fiscal consolidation, "sometimes called austerity, which is shorthand for policies to reduce fiscal deficits and debt levels".

Ostry, Loungani and Furceri said that based on their assessment they reached three disquieting conclusions: The benefits in terms of increased growth seem fairly difficult to establish when looking at a broad group of countries, the costs in terms of increased inequality are prominent, and increased inequality in turn hurts the level and sustainability of growth.

"Even if growth is the sole or main purpose of the neo-liberal agenda, advocates of that agenda still need to pay attention to the distributional effects," the researchers said.


They suggested that many countries, such as those in southern Europe, have little choice but to engage in fiscal consolidation, because markets will not allow them to continue borrowing.

"But the need for consolidation in some countries does not mean all countries - at least in this case, caution about 'one size fits all' seems completely warranted," they said.

They suggested that even for countries with a strong record of being fiscally responsible, the benefit of debt reduction, in terms of insurance against a future fiscal crisis, turns out to be remarkably small, even at very high levels of debt to GDP.

According to the researchers, "faced with a choice between living with the higher debt - allowing the debt ratio to decline organically through growth - or deliberately running budgetary surpluses to reduce the debt, governments with ample fiscal space will do better by living with the debt".

The IMF researchers contended that austerity policies not only generate substantial welfare costs due to supply-side channels - they also hurt demand, and thus worsen employment and unemployment.

The researchers noted that the notion that fiscal consolidations can be expansionary - that is, raise output and employment - in part by raising private-sector confidence and investment, has been championed by, among others, Harvard economist Alberto Alesina in the academic world and by former European Central Bank President Jean-Claude Trichet in the policy arena.

However, with fiscal consolidation, the short-run costs in terms of lower output and welfare and higher unemployment have been underplayed, and the desirability for countries with ample fiscal space of simply living with high debt and allowing debt ratios to decline organically through growth is underappreciated, the authors said.