Countries planning budget cuts are most likely to feel the pinch when other nations make reductions simultaneously and they don’t have leeway to cut interest rates, the International Monetary Fund said.
After the global recession, with their public debt matching the size of their economy by the end of the year “virtually all advanced economies will face the challenge of fiscal consolidation,” the IMF said in parts of its World Economic Outlook report released today. Such tightening “typically reduces output and raises unemployment.”
Advanced economies that saw their fiscal gap widen as the global recession squeezed revenue are now seeking to outline tightening plans. In Europe, which set up an emergency aid mechanism worth almost $1 trillion in May to halt a sovereign- debt crisis, Portugal and Ireland are now struggling to convince investors that they can regain control of their finances.
The IMF said its findings “suggest that budget deficit cuts are likely to be more painful if they occur simultaneously across many countries, and if monetary policy is not in a position to offset them.”
Lower borrowing costs can help cushion the effect of tightening on growth, the IMF said in the report released in Washington, though it’s not an option available to “a number of countries” that currently have interest rates close to zero.
The U.S. Federal Reserve has kept its benchmark interest rate in a range of zero to 0.25 percent since December 2008, while the European Central Bank’s benchmark rate has been 1.0 percent since May 2009.
The IMF on Sept. 27 said the U.K.’s fiscal consolidation plan “will help rebalance the economy” while benefits from the plan “outweigh the expected costs in terms of adverse effects on near-term growth.”
A decline in the real value of a country’s currency also helps limit the impact on growth by boosting net exports, though this cannot work for too many countries at the same time, according to a part of the report released today. In addition, countries in a monetary union also have less scope for a currency depreciation, it said.
European countries from Greece to Spain have adopted austerity measures to reduce their budget shortfall, including public-sector wage cuts and increased taxes.
Tightening-measures that target spending cuts have a softer impact on growth than tax increases, mainly because central banks provide less monetary stimulus when indirect taxes threaten to fan inflation, it said.
Still, “fiscal consolidation is likely to be beneficial over the long term,” the IMF said. “In particular, lower debt is likely to reduce real interest rates and the burden of interest payments.”
Separately, the IMF urged policy makers to engage in changes of their economies to boost productivity and enhance demand for imports.
Officials should also take steps to improve access to credit, continue to constrain protectionist tendencies and avoid exchange-rate volatility, the IMF said. A conclusion of the Doha Round of global trade talks would also help revive global trade.
In the six months straddling the last quarter of 2008 and early 2009, the annualized drop in world imports was more than 30 percent, the IMF said. That compared with a nearly 6 percent drop in global output during the same period.
Should sovereign debt crises erupt, imports would deteriorate and world trade would be slower to recover, the report said.
The recovery of import demand in the U.S. and much of Western Europe may be “even more protracted than suggested” by their relatively weak projected recoveries in output, largely because those economies also experienced financial crises, had weak external balances and suffer from contracting or slowing credit, the IMF said.
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