Has austerity gone too far?

by Giancarlo Corsetti and Gernot Müller

Vox
February 20, 2012

Numerous countries faced with debt problems have recently embarked on fiscal tightening. Yet it is not clear if this is a cure or a self-defeating strategy. This column argues that, where sovereign risk is high, fiscal tightening remains an important avenue to bring down deficits at a limited cost to economic activity.

Numerous industrial countries, especially in Europe, have recently embarked on fiscal tightening. The measures adopted so far have not proved a cure-all for financial market concerns about debt sustainability. Tighter fiscal policy has, however, coincided with renewed economic slowdown or even contraction. Against this backdrop, the ranks of commentators who view austerity as potentially self-defeating have swollen. Paul Krugman (2012) and Carlo Cottarelli (2012), for example, argue that the weak output growth caused by fiscal austerity may itself fuel market doubts about government solvency. Higher funding costs, combined with lower activity, might thus worsen the fiscal position, defeating the very purpose of the initial tightening measures.

So should governments relent in their efforts to reduce deficits and restore safer fiscal positions? Drawing on the formal analysis in a recent paper of ours (Corsetti et al. 2012), we argue that this may not be the right conclusion. Although each country needs to be judged on its own specific circumstances, there are sound arguments for fiscal austerity under certain conditions.

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