Overview Of The Financial Consolidation

Financial consolidation (FC) relates to a large fall in the deficit by more than 1.5% of GDP. The assumption is that a sharp reduction in the cyclically adjusted deficit would have to be a result of some policy action such as an increase in tax (T) or reduction in government spending (G) rather than an occurrence of chance. The Financial crisis was a result of liquidity issues within large banks. The wider implication of this is that many governments such as the UK’s have inflated unsustainable deficit levels (£156 billion). The consequence of which includes a higher interest rate, weak discretionary fiscal ability and a greater likelihood of future shocks with deeper impacts. Furthermore Austerity reduced crowding out effects, thus improving the ease of access, Private firms have to capital markets, their standing with depositors and ability to make loans which encourage investment and growth. FC can have direct demand effects and also an impact on expectations.

Ricardian equivalence (RE) shows that FC’s infers agent’s diss-save in the current period to keep their trend consumption smooth. Thus in theory FC’s should encourage consumption and investment in the economy. Still RE requires perfect rationality and incentives which align with policy maker views, which is unrealistic. Reinhart & Rogoff (2012), state there is a threshold (>90%) for the debt/GDP ratio beyond which growth collapses. Osborne used this to back austerity although the deficit as a percentage of GDP was only 6.9% relative to Greece’s at 146.2% in 2010. Researches showed several errors (omission of available data, weighting…) reducing the mean GDP growth of countries in the high public debt category” in the RR data. Furthermore RR’s approach does not account for typical determinates of growth (investment/saving ratios, education, institutions, openness…). Thus Chudik et al. (2015) uses sophisticated econometric models to show that there is no universal debt threshold, rather finding a higher/rising ratio is associated with falling growth rates. The coalition’s choice of FC’s originally, reduced UK growth according to the OBR estimates by 2%.

Wren-Lewis (2015) states FC measures should have been implement at a better time, as sharp FC’s cannot be used at a time where the interest rate is at the zero lower bound and aggregate demand is depressed. Key is that government spending is a component of AD, thus the austerity Measures in the UK cemented the economy in a lower income path. Taylor (2013) argues there was no need for austerity as the government would benefit from reverse automatic stabilizers, highlighting long term costs. A 1% loss of GDP due to Austerity leads to a depressed output of about 0.7% per year. He claims decisions taken pre-crisis are the cause of the fortuitous recovery of some nations not austerity. Propagators of austerity favor cutting G. Alesina & Ardagna (2012) state that certain combinations of polices allow for austerity to be associated with growth. The IMF using the narrative approach, claim that Monetary policy is the explanation for the systemic difference between T and G based consolidations. They further add that the asset price boom affecting tax revenues and deficits where not being taken into account in the standard cyclical adjustments used by. FC’s are difficult to assess as the method of cyclically adjusted primary balances (CAPB) is not exhaustive thus can yield tainted Austerity episodes. CAPB is biased as it plays down shrinkages and amplifies expansions. However through econometrics come to the IMF conclusions in that “Only a strong economy can bear a fiscal consolidation without significant output losses.” The view at the time was that Austerity was a one size fits all policy however this is not the case. The lack of available samples, causality issues and methodology issues mean that the case for FC is flawed from its onset, which is in line with the criticisms that have been outlined.