by Don Alexander, MBA
Associate, RSD Solutions Inc.
A key question for risk management is how to manage risk and by how much. A recent short VOXEU communique (3rd April) called The Austerity Question: ‘How’ is as Important as ‘How Much’ by Alberto Alesina & Francesco Giavazzi asked the same question when policymakers attempt to implement austerity measures.
Alesina & Giavazzi note that in Europe’s embrace of fiscal austerity has sparked a debate among economists. These authors argue that the debate has gone astray – focusing exclusively on the size of the deficit reductions. The focus of policymakers should be on the budget tightening’s composition (tax versus spending) and the accompanying policies. The key question is not “how far” governments go but “how” they go far enough.
Until the critical principle – ‘how’ as important as ‘how much’ – is embraced, the austerity debate in Europe will continue to be completely out of line with the real economic trade-offs.
Economists note the following evidence by the implementation of austerity: spending cuts are less recessionary than those achieved through tax increases, and the use of spending cuts with the right policy may limit the economic impact when compared to other policy measures.
Policymakers should stop focusing fiscal policy discussions on the size of austerity programs. Recent IMF research suggests a relatively small tax-based adjustment could be more recessionary than a larger one based upon spending cuts. Likewise, a small spending-based adjustment could be more effective at stabilizing debt-to-GDP ratios than a larger tax-based adjustment.
A number of questions need to be considered: what spending cuts are more effective, can tax reforms achieve the same revenue with minimal distortions and how should market liberalization be implemented? In general moving taxation towards the VAT and away from income taxes is preferable. In some countries, there is no solution without a substantial raise in retirement age and cuts in government employment. This includes the implementation of labor-market reforms, especially in the public sector.
Until the critical principle “how” is as important as “how much” is embraced the austerity debate in Europe is out of whack with the real economic consequences. Europe is in for a big disappointment on the centerpiece of Eurozone austerity – the fiscal compact. The compact bears the seeds of its own failure: the treaty change makes no mention of the composition of fiscal packages, and encourages adjustments mostly on the tax side, suggesting that European economies will remain stagnant and debt ratios will not come down. In the end, as was the case with the Growth and Stability Pact, the rules will be abandoned.
The lesson for risk management is not just the identification of potential risk, but the methodology used to manage it and its potential consequences.
For more on this, follow the link: http://www.voxeu.org/index.php?q=node/7836
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