Friday, October 1, 2010

Flaw found in joint plans to cut deficits

IN A finding with dismal implications for the world economy, the International Monetary Fund has found that the new wave of simultaneous deficit reductions in key Western economies is likely to be far more painful than their governments assume.

A major new IMF study tackles the hottest topic in global economics whether it is more important for the United States, Britain and other countries with high unemployment and high deficits to spend up to stimulate jobs, or cut spending to bring their budgets back under control.

The IMF research, published as an early chapter from next week's World Economic Outlook, concludes that cutting spending is the right path in the long term. But it warns that the costs will be far higher and longer lasting than some have estimated.

It tears apart two influential studies by American-Italian economists Alberto Alesina and Silvia Ardagna, which found that fiscal consolidation rarely does much short-term damage to the economy, and can even bring immediate gains. The Cameron government in Britain, and others, have cited this research to justify heavy spending cuts.

But the IMF study apart from accusing Alesina and Ardagna of choosing their examples selectively found this was true only when isolated countries carried out fiscal consolidation, when interest rates were free to fall, and a slump in domestic demand was offset by rising exports.

None of those conditions was true now, the IMF warned. It endorsed arguments by columnists Paul Krugman of The New York Times and Martin Wolf of the Financial Times that Western countries cannot collectively export their way out of a domestic slump, since most of their exports go to each other.

When isolated countries cut spending sharply, as Australia did in the late 1980s, the study found, a budget cut of 1 percentage point of GDP created a similar cut in domestic demand. But an expansion of net exports halved the GDP cost, while interest rate cuts cushioned demand.

By contrast, the costs to GDP are doubled when the rest of the world is also cutting spending, and doubled again when interest rates are already too low to allow further cuts.

Over the long term, however, the study found that fiscal consolidation more than pays for itself, by increasing investor confidence, allowing lower interest rates, and allowing governments room to cut income tax.

It found that spending cuts deliver more long-term gain than tax rises, mostly because central banks are more likely to cut interest rates to offset the impact.