IMF fears cuts will damage growth

Financial Times:

Slashing government spending to reduce debt burdens will have unusually damaging effects on growth because of the weak global economy, according to International Monetary Fund research.

Excerpts from the IMF’s twice-yearly economic outlook, which will be published in full just before next week’s annual IMF-World Bank meetings, argue that some studies have underestimated the contractionary effects of rapid cuts in government spending.

The IMF takes aim at the conclusion in these studies that fiscal consolidation can boost economic growth.

The impact of austerity measures are cushioned by a weakening currency, strong export demand and cuts in interest rates – factors absent in most big advanced economies.

“We should not kid ourselves. In the short term, tax hikes and spending cuts will reduce growth and raise the unemployment rate,” said David Leigh, the IMF economist who led the study.

The findings support the arguments US administration officials have been making this year, that embarking on rapid fiscal austerity measures could do more harm than good.

“Our findings suggest that in today’s environment, fiscal consolidation is likely to have more negative short-term effects than usual,” the IMF economists concluded. “If many countries adjust simultaneously, the output costs are likely to be greater – since not all countries can reduce the value of their currency and increase net exports at the same time.”

The report suggests a reduction of 1 per cent of gross domestic product in the fiscal deficit will reduce GDP growth by 0.5 per cent and increase unemployment by 0.33 per cent within two years.

But provided underlying growth is sufficiently strong a slide back into recession can be avoided.

But with governments cutting simultaneously and without reductions in interest rates, the effect could be twice as large, it says.

Governments and economists calling for rapid austerity measures have pointed at examples such as Canada in the 1990s, where huge cuts in spending were rewarded by rapid rebounds in growth.

But Paul Martin, Canadian finance minister at the time, says those lessons do not hold. “We sent down one of the most austere budgets ever, but we did so during a rising economy,” he told a conference in Seoul this week. “The issue is not whether you cut spending but whether you cut the deficit – in some cases that will mean doing the opposite with spending.”

The findings are likely to be welcomed in the US administration, where there is some frustration that the IMF has this year lined up in favour of rapid deficit reduction.