If austerity measures are adopted only after considerable delay or are not implemented as enacted, investor reactions are unlikely to be positive. Then the directly negative impact of austerity policies will dominate, leading to low or negative revenue growth and increased budget deficits. This can also occur when policymakers appear to change their minds and retract budget-consolidation measures midstream in response to political pressure. The resulting loss of market confidence can be long-lasting and damaging to prospects for economic growth.
Moreover, if adverse market reactions occur when particular policies are announced and implemented, it must mean that policymakers did not do their homework: They did not correctly judge the expectations of market participants. Indeed, some observers may believe that strongly adverse market reactions are themselves a source of economic shocks that need to be countered through policy revisions. This appears to be the case with the IMF’s recommendation, following its recent forecasts of reduced growth in Europe, to go slow on austerity measures.
What about the United States? It’s also an example of economic underperformance resulting from a wavering implementation of policies. No sooner was the Budget Control Act of 2011 signed into law than leaders of both parties began to explore ways to avoid its sequester provisions. The U.S. economy already faces gargantuan uncertainties: the fate of the health-care law, the future course of the Bush tax cuts, unsustainable Medicare and Social Security commitments, unavoidable post-election skirmishes on extending the federal debt ceiling, and strife over sorely needed fixes to the Alternative Minimum Tax and Medicare’s doctor-reimbursement rates. Such a long to-do list is surely curbing the willingness of investors to take risks and of employers to hire. Unfortunately, no cures will be forthcoming until after the elections in November, and perhaps not even then.
Leaders in Europe and the U.S. have used the trial-and-error method to precisely calibrate an optimal set of policies for boosting economic growth while simultaneously curbing government expenditures to reduce debt over the medium term. Given the political and economic uncertainty facing developed nations, that appears to be an exercise in futility. Policymakers should set a particular fiscal course for Europe as it faces its debt crisis — and then go on an extended vacation, to avoid continually recalibrating austerity measures. In the U.S., where medium-term national debt continues to escalate, expensive political theater will have to continue for a while longer.
— Jagadeesh Gokhale is a senior fellow at the Cato Institute.