The holy grail of high growth with low spending

By Felix Salmon
June 25, 2010
Wolfgang Schäuble, calls this "expansionary fiscal consolidation" -- but is it a chimera, or does it actually exist?

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In the ongoing debate over whether or not this is the right time for fiscal austerity, everybody seems to be able to agree on one thing: the holy grail is to be able to have your cake and eat it, by reducing deficits while at the same time accelerating economic growth. Germany’s finance minister, Wolfgang Schäuble, calls this “expansionary fiscal consolidation” — but is it a chimera, or does it actually exist?

Mohamed El-Erian, for one, seems to think that such a thing does indeed exist, calling on industrialized economies “to adopt both fiscal adjustment and higher medium-term growth as twin policy goals”. And how exactly are they meant to do that?

To begin to achieve both, countries must quickly implement what were once known in the emerging market lexicon as “second generation structural reforms”…

Squaring the circle of growth and fiscal stability needs policies that focus on long-term productivity gains and immediate help for those left behind. This means first enhancing human capital, including retraining parts of the labour force, and increasing labour mobility. Then new emphasis on infrastructure and technology investment is needed, with greater support for scientific advances that promise increased productivity. Finally all nations must begin an honest assessment of the social frictions coming in the next few years. In some countries (like the US) this means an urgent bolstering of social safety nets.

The experience of emerging economies cautions that such reforms are difficult to design, and politically hard to implement. They often mean short-term pain for long-term gain – the reason policymakers take so long to realise they are the right path.

There’s something missing here: the short-term pain. Everything that El-Erian mentions is politically easy to implement, in that it involves increased, rather than decreased, government spending. So where does the pain come from? Do taxes need to rise? Must spending elsewhere be cut?

Olivier Blanchard and Carlo Cottarelli, at El-Erian’s alma mater, the IMF, have more specifics. Yes, they say, the US will have to raise taxes. And cut spending:

Some cuts should be no brainers: for example, shifting from universal to targeted social transfers would involve significant savings, while protecting the poor. Containing public sector wages—which have risen faster than GDP in several advanced countries in the last decade—will be necessary.

But by far the most important thing is to get a grip on healthcare costs:

Increases in pension and health care spending represented over 80 percent of the increase in primary public spending to GDP ratio observed in the G-7 countries in the last decades. The net present value of future increases in health care and pension spending is more than ten times larger than the increase in public debt due to the crisis.

Any fiscal consolidation strategy must involve reforms in both these areas… Given the magnitude of the spending increases involved, early action in these areas will be much more conducive to increased credibility than fiscal front-loading. And will not risk undermining the recovery. Indeed, some measures in this area—while politically difficult—could have positive effects on both demand and supply.

If you make consistently good fiscal decisions, the effects on a country’s debt ratios can be huge:

Strong growth has a staggering effect on public debt: a one percentage point increase in potential growth—assuming a tax ratio of 40 percent—lowers the debt ratio by 10 percentage points within 5 years and by 30 percentage points within 10 years, if the resulting higher revenues are saved.

Realistically, of course, those higher revenues won’t be saved — unless the government can credibly pre-commit to a medium-term fiscal timetable. And such credible commitments are extremely difficult to design — especially when they’re so contingent on cracking such tough nuts as healthcare spending.

“Obey these commandments,” say Blanchard and Cottarelli, “and chances are high that you will achieve fiscal consolidation and sustained growth.” They’re too polite to say that if you don’t obey their commandments, then the chances are low that you will get what you’re looking for. But that’s got to be the base-case scenario in most of Europe and the US.


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Only to focus in this situation on GDP growth is imho slightly wrong. It is also real money available for real spending.
1.Main problem will be that probably 60-80% of the population (of the Western world) won’t see much income increases in the next 1 or 2 decades. Their wages are x-times higher than normal if you take the world as a reference. Continuation of outsourcing to developing countries will continue, more people for the same number of jobs, leads to lower wages. Only geographicly non transferable jobs will remain in this part of the labor market. Or in Europe jobs that require people to speak a language that is rather unique and not spoken in the rest of the world(like Danish, or Dutch).
2. Borrowing either as Government or privately is stretched to the max, so there are not many other ways to finance consumption.
3. Because of eg deleveraging structural economic growth of the US will be lower than in pre crisis time, where a lot of the growth was financed with borrowed money.
4. In Europe it will be substantially worse than in the US as they will have to cope with aging as well, which is much less of a problem than in the US. Plus their (unproductive) government sectors are bigger relatively.
5. Main sectors where savings can be made are imho:
-Government (in general a very unproductive sector).
-Healthcare (especially in the US, allthough there it is still mostly private sector and privately financed).
6. To start with healthcare probably a 2 class system is also unavoidable in Europe. Basic one for everybody.
In the US probably some way to get rid of the costs which doesnot provide better healthcare as such, but better service and nicer looking hospitals and insurances and all treatments at the same time starting with the most expensive one.
7. Healthcare won’t be much of a saving anyway it is more keeping cost rises as low as possible.
8. Remains Government spending. If Government would work more efficient likely huge costsavings can be made. As well as looking at efficiency of their laborforce also efficiency of programms.
9. In Europe in general this is probably the only way to give normal people more to spend (through lower taxes) for the next decade or maybe 2.
10. For the US the situation looks slightly better, allthough if successive government continue spending like they did the last decade that advantage might have to be used for debt repayment.

Posted by Rikh | Report as abusive

Step number one: While in the throes of a fiscal crisis don’t commit to massive new entitlement spending.

Oh, oops.

Posted by DanHess | Report as abusive

Not sure whether it’s just bad timing or in worse than customarily poor taste but it ill behooves IMF stentorian evangelists to preach the virtue of budgetary austerity after all they’ve done to abet institutional prodigals in getting theirs first and at no matter what cost to the general populace.

Not until they’ve actually paid the piper with their own money.

Posted by HBC | Report as abusive

How about low growth and high spending?
Judging by results so far, it’s a more popular policy, possibly because it’s easier to implement…

Posted by yr2009 | Report as abusive

Ah yes, the old “politically difficult.”
So all we need is an entire generation of politically-suicidal elected officials at every level of government in the dozen or so largest global economies? (Except China – semi-benevolent dictatorship has its advantages)
I don’t see any problem with that.

Posted by Rockfish | Report as abusive