Austerity and recovery: East Asian lessons for Europe

By Peter Henry and Anusha Chari

Comparing the divergent recoveries in Europe and East Asia also yields the conclusion that, in response to similar crises, it is not simply the size of the fiscal stimulus that matters but also its variability and persistence.

In the wake of the Great Recession, a contentious debate has erupted over whether fiscal consolidation, less formally known as ‘austerity’, is helpful or harmful for economic growth. One side argues that austerity is expansionary when achieved via spending cuts rather than tax increases (Alesina and Perotti 1995, Alesina and Ardagna 2010). An alternative view, consistent with textbook prescriptions for countercyclical fiscal policy, suggests that fiscal consolidation is harmful to growth when implemented in the midst of a crisis (Blanchard and Leigh 2013). Both camps, however, ignore the wealth of information inherent in comparing the economic performance of countries that pursue fiscal austerity with those that opt for a different path.

In contrast to the previous literature on fiscal adjustment, this is precisely the approach we adopt in a new paper, “Two Tales of Adjustment: East Asian Lessons for European Growth” (Chari and Henry 2015). Roughly a decade apart, East Asia and Europe were each struck by recessions caused by a similar set of factors: excessive lending (especially in real estate) leading to a high incidence of non-performing loans and failure of financial institutions, followed by a severe credit crunch. Leaders of East Asia responded with standard textbook expansionary fiscal policy, while European leaders switched from fiscal expansion to consolidation before their crisis-ridden economies had recovered.

Using a macro case study in the spirit of the policy experiment approach (see Henry 2007, Henry and Miller 2009), we exploit the similarities between the causes of the Asian financial crisis of 1997–1998 and the Global Crisis of 2008–2009 – and the differences in economic policy responses – to provide a setting in which we can more definitively answer the following question: Did the large and abrupt reversal from fiscal stimulus to fiscal consolidation in Europe at a moment when output was still falling cause its post-crisis recovery to be slower and less complete than it would have been in the absence of this policy reversal?

Read the full article as published in Vox.

Peter Henry is the Dean of the Leonard N. Stern School of Business, Dean Richard R. West Professor of Business and William R. Berkley Professor of Economics & Finance.