Fiscal Consolidation in Europe

The U.K. has become the latest country to join the wave of fiscal consolidation in Europe.  Making the fiscal policy sustainable, especially after the post-crisis fiscal stimulus packages, is important, but the government should avoid tightening the fiscal policy too rapidly.

The experience in Japan in the mid 1990s offers an example of tightening too quickly.  In 1996, many observers believed that the Japanese economy was finally coming out of the post-bubble recession.  The real growth rate for 1996 was about 4%.  The Japanese government thought this was a good time to start addressing the issue of mounting government debt.  The debt to GDP ratio was quickly approaching 100%.  So the government stopped the fiscal stimulus, phased out the income tax cut, increased the consumption tax from 3% to 5%, and increased the copay on health insurance in 1997.  Ex post this was a mistake and Japan got back into recession.

The economic recovery in Europe today does not seem to be as robust as the Japanese recovery in 1996.  This should make us worry about the impact of fiscal consolidation in Europe today.  Unless it is combined with massive monetary expansion, the fiscal consolidation is likely to slow down the European economies and put many of them back into recession.  And monetary expansion is difficult when the policy interest rate is near or at zero.

The best response would be to credibly announce the plan for fiscal consolidation in the near future without cutting government expenditure or raising taxes too quickly.  I guess this is easier said than done.