IMF Says Budget Cutting Needs ‘Speed Limits’ Even Under Pressure

Countries should observe “speed limits” and avoid narrowing fiscal deficits too quickly, even when they face pressure from investors justifying a large debt reduction, according to International Monetary Fund staff.

“As we have seen for some euro-area members, countries in a weak fiscal position that are facing market pressure or have lost market access have undertaken large and front-loaded adjustments,” according to a report by IMF economists released today. The research compiles lessons from the global financial crisis and the debt turmoil that followed in Europe.

“In many countries, fiscal imbalances are of such magnitude that addressing them in the near term would require adjustment on a scale that would dramatically impact economic activity and would have devastating consequences for the provision of government services,” the staff said in the report.

The IMF has been softening its support for fiscal austerity in recent years as Chief Economist Olivier Blanchard argued that budget cuts had caused a deeper-than-expected reduction in European growth. Countries including Greece and Portugal, which received joint loans from the IMF and the other euro-region nations, were granted more time to meet deficit targets.

“Even for countries under market pressure there are ‘speed limits’ that govern the desirable pace of adjustment,” the IMF staff wrote.

The effectiveness of fiscal stimulus to support growth in the aftermath of the financial crisis showed it can be a powerful tool when central banks have reduced interest rates to zero and the financial industry is weak, according to the report.

At the same time, investors turning against countries in the euro region debunked the view that a full debt crisis in advanced economies was a remote possibility, according to the report. As a result, the debt level that policy makers should target in the long term should be lower than it used to be, it said.