The age of austerity may be nearing an end. After three years of belt-tightening, governments from Washington to Madrid are easing up. That may be good news because one of the forces tempering recoveries in the U.S. and Europe is what economists call the fiscal drag. The term refers to the restraining effect budget chopping has on economic growth. The bigger it is, the more businesses and households rein in their own spending in response to less government hiring or curtailed public investment on things such as public works and education programs. “The softening of the fiscal drag is likely to play an important role in supporting a pickup in global growth,” says Jose Ursua, an economist at Goldman Sachs (GS).
Policymakers have room to maneuver because budget deficits are narrowing, thanks in large part to earlier cost-cutting efforts. Improving economies are also helping to close the gap by bolstering tax revenue. When interest payments on debt are excluded and swings in the economic cycle are smoothed out, the International Monetary Fund forecasts the deficits of the Group of Seven countries will average 1.2 percent of gross domestic product in 2014, down from an average of 5.1 percent in 2010.
Economists at Goldman Sachs and Deutsche Bank (DB) expect industrial economies almost to double their rate of expansion next year, to 2.2 percent, as policymakers relax spending controls. The U.S. budget that the Senate approved on Dec. 18 restores $63 billion in spending over the next two years, effectively rolling back more than half of the automatic cuts known as sequestration. Barring another showdown over the debt ceiling in February, Ursua says, the budget deal should help spur the U.S. economy toward 2.8 percent growth next year, up from 1.7 percent in 2013.
The improving fiscal health of U.S. state and local governments also bodes well for the economy. Their $1.74 trillion in inflation-adjusted spending is 50 percent higher than the federal sector, and they employ seven times more people, according to Joseph LaVorgna, chief U.S. economist at Deutsche Bank. Having declined for three consecutive years, state and local government spending jumped 1.5 percent in the third quarter of 2013, the most since the second quarter of 2009. “The positive incremental effect from stronger state and local activity is considerable,” says LaVorgna, who predicts the U.S. will expand 3.2 percent next year after 1.8 percent this year.
Austerity is also starting to give way in Europe, where it helped deepen the longest recession since the euro began trading in 1999. With countries under less pressure from bond investors to tackle excesses, fiscal policy across the continent won’t be restrictive for the first time since 2009, predicted Giada Giani, an economist at Citigroup (C) in London, in a Nov. 22 report.
Ireland, which is poised to be the first European economy to exit the region’s bailout program, is scaling back the €3.1 billion ($4.2 billion) in cuts it originally sketched out for next year to €2.5 billion. Spain’s government is pledging no more tax increases and promises to cut taxes before the next election in 2015.
In Europe, it may take until 2015 for the effects of all the cutbacks to diminish, given that policies implemented in 2013 have yet to take full effect, according to Laurence Boone, chief European economist at Bank of America (BAC) Merrill Lynch. Boone expects the euro area to grow 0.8 percent next year, after shrinking 0.5 percent in 2013. “It’s important overall the drag disappears,” she says.