This article reviews some of the opinions expressed in ‘Asset Prices and Monetary Policy: Four Views’ by Mark Gertler, Marvin Goodfriend, Otmar Issing and Luigi Spaventa (CEPR/Bank for International Settlements, 1998)

Are public deficit reduction programmes always contractionary and unpopular? New CEPR research indicates that the opposite is often true: fiscal stabilization policies may actually have expansionary effects. What’s more, public opinion often rewards politicians for administering the tough medicine.

After the fiscal profligacy of the 1970s and much of the 1980s, most OECD countries have tried to put their public finances in order during the last decade. The Maastricht convergence criteria have prompted many European countries to engage in sizeable fiscal retrenchment programmes in order to stabilize their debt to GDP ratios. And the Growth and Stability Pact provides a strong additional incentive to governments attempting to achieve budgetary balance.

The nature, consequences and degree of success of these fiscal programmes have varied widely. Some fiscal adjustments have led to a permanent consolidation of the government balances. Others failed and were soon followed by more deficits. It is commonly believed that such policies inevitably reduce economic growth, but several of these fiscal adjustments led to a boom rather than a recession.

How can these different outcomes be explained? Which features of fiscal adjustments imply that fiscal tightening will be successful or unsuccessful in pushing government budgets along long-lasting ‘sustainable’ paths? And what makes a fiscal adjustment expansionary or contractionary? These questions are addressed by Alberto Alesina and Silvia Ardagna in ‘Tales of Fiscal Adjustments’, an article in the latest issue of Economic Policy.

Alesina and Ardegna use statistical evidence on fiscal consolidations in OECD countries from the early 1960s to the present day and, in addition, examine ten specific cases in more detail. They identify the type of fiscal adjustment that is associated with a booming economy and a permanent consolidation of government finances:

First, the successful, long-lasting and expansionary adjustment is on the spending side of the budget. In particular, it involves large cuts in government wages and transfer programmes, including pensions. Taxes are not increased.

Second, the successful adjustment is accompanied by policies of wage moderation, generally achieved by consensus with the unions. Wage moderation is particularly important when, as it is sometimes the case, fiscal adjustments are accompanied by a devaluation and a consequent rise in the price of imported goods.

The researchers conjecture that these measures result in more efficient labour markets and boost labour supply. A successful fiscal adjustment also boosts aggregate demand with private investment reacting most strongly and positively to a successful fiscal adjustment. Cuts in transfers, welfare programmes and the government wage bill, wage moderation and devaluation policies all keep unit labour costs low and improve firms’ competitiveness and profitability, hence sparking investment and growth. Indeed, profits surge during successful fiscal adjustments.

Alesina and Ardagna also study episodes of fiscal expansion - increases in deficits - and find results consistent with these composition effects. In particular while tax cuts have expansionary effects, especially on investment, spending increases have a contractionary impact on private investment.

Fiscal contractions, and spending cuts in particular, have the reputation of being ‘politically costly’. These researchers investigate whether governments that have pursued spending-based fiscal consolidations have been punished by the voters. The answer is no: there is no evidence that governments engaging in expenditure-based fiscal stabilization systematically lose voters’ support. The reason why governments are so reluctant to cut certain type of spending is that certain key constituencies have a disproportionate influence on the government decision process. These constituencies include public and private sector unions and overly protected groups of pensioners.

The shining example of a successful, growth-creating fiscal adjustment is Ireland’s programme of the late 1980s. This fiscal consolidation was entirely on the spending side, and following its implementation, the Irish economy has been growing at exceptionally high rates, well above the European average.

In contrast, other European countries have tried to satisfy the Maastricht treaty’s 3% budget deficit to GDP rule through fiscal adjustments on the tax side. The case of Italy is the clearest: from the early 1990s, tax rates in Italy have increased by a staggering 6 percentage points of GDP, reaching almost 48%, while spending on government wages and transfers as a fraction of GDP has not been cut at all. Across the 1990s so far, the average rate of growth in Italy has been only slightly above 1% a year, despite the transitory effect of the devaluation of 1992.

What does all this mean for monetary union? The researchers suggest two important policy implications.

First, the countries that join the monetary union will have to maintain a balanced budget over the business cycle. European governments will have only one course of action: significant cuts in spending to meet the requirements of the Growth and Stability Pact without increasing the tax burden. The only way to cut spending that is not ‘window dressing’ is to trim overextended welfare states, especially pensions and the government wage bill. In fact, European governments should also achieve the goal of significantly reducing the tax burden through deep spending cuts. This is the only way to reduce the level of unemployment and increase long-run growth.

Second, expansionary fiscal policies, which may be called for by the current threat of worldwide recession, will have to be based on tax cuts compensated by spending cuts, rather than the other way around. This runs contrary to the current view expressed by several European officials and government ministers that increased spending on public projects is needed, even at the cost of relaxing the Maastricht criteria. Spending increases have a high probability of being contractionary, Alesina and Ardagna conclude, because they will lead to expectations of tax increases - a particularly harmful effect given the already high tax burden.

Over the last few years, several of the best regarded financial houses have been shaken by huge frauds, often with lethal effects. While each of these headline-grabbing stories has its own explanation, it no longer seems credible that these are isolated events. There is a glowing perception that the combination of globalization and computer-based technological change makes fraud likely to occur and harder to detect. Could it be that crime in the securities industry is increasingly escaping internal and external controls?

In Economic Policy 27, Norvald Instefjord, Patricia Jackson and William Perraudin examine seven prominent episodes of securities fraud or irregular financial market activity. Finding a number of common patterns in these cases, including poor internal controls and inadequate punishment by both firms and watchdog bodies, they use standard tools of economic policy analysis to explore how such episodes can be made less frequent.