by Don Alexander, MBA
Associate, RSD Solutions Inc.
The purpose of models is not to fit the data, but sharpen the questions.
(Samuel Karlin)
Carlo Cottarelli, in a VOXEU communique “Fiscal Adjustment: Too Much of a Good Thing” dated Feb. 8th notes that a sharp reduction in budget deficits in certain circumstances can actually increase risk. This raises a question when we attempt to mitigate risks: Does a rapid adjustment actually increase risk?
Almost everyone agrees that the fiscal accounts of several advanced economies are in bad shape and need to be strengthened. But how fast should the adjustment be in the present circumstances. At time over the last couple of years, the IMF has called on countries to step up the pace of adjustment when they were perceived as moving too slowly. The IMF has argued that countries should reduce public-debt ratios through a gradual and steady process. However in the current environment, some countries are moving too fast.
The IMF Fiscal Monitor (Jan. 2012) indicates deficits are projected to fall by 2% of GDP in 2011-12 in the advanced economies, 3% in Eurozone countries. Adjustment is reasonable in a good growth environment, but in a weaker macroeconomic environment bringing down this quickly can increase risk to the economic recovery. IMF research suggests fiscal adjustment that lower debt ratios and deficits can reduce government bond spreads when the impact on growth is limited. Conversely, when tightening fiscal policy reduces growth, bond spreads can widen, especially with weak growth and fiscal tightening is large.
In advanced countries with limited financial options, deficit reduction is the best alternative. Structural reforms to boost competitiveness and growth along with deficit reduction are critical, but take time to work. It is important for countries to adjust at an appropriate pace and have adequate financing to boost confidence as market perceptions adjust (such as through the European Financial Stability Facility and the European Stability Mechanism). Markets eventually respond to better fundamentals with stronger growth and reduced deficits, but this can take a while.
If growth slows, countries should avoid further fiscal tightening. Countries with flexibility, such as some Eurozone members with lower interest rates, can slow the pace of deficit reduction. The projected 2% reduction in the U.S. deficit in 2012, the largest in forty years, is excessive. It is more important for countries, such as the United States, to formulate credible medium-term adjustment plans and gradually reduce the deficit. The adoption of credible medium-term adjustment plans, which is missing in many advanced countries, would reduce uncertainty. The cost of policy uncertainty is high, especially if growth starts to slow.
Can we learn anything for risk management?
For more on this follow the link: www.voxeu.org/index.php?q=node/7604
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