Addressing the sovereign debt overhang in Europe and the US, Paul Krugman often refers to the 'confidence fairy', the idea that if budget austerity is clearly in the interests of the economy, the public will understand the benefits. Thus tough austerity boosts public confidence and spending, which compensates for the budget measures. Thus the debt problem can be fixed without sacrificing growth.

As Krugman never tires of pointing out, the fairy's appearances have been so rare that we should doubt her existence. But no need to rely just on Krugman's views. The IMF has recently done an exhaustive study which concludes, uncharacteristically definitively, this way:

...a fiscal consolidation of 1% of GDP reduces inflation-adjusted incomes by about 0.6% and raises the unemployment rate by almost 0.5% within two years, with some recovery thereafter...fiscal consolidations are contractionary, not expansionary. This conclusion reverses earlier suggestions in the literature that cutting the budget deficit can spur growth in the short term.

From an organisation which has an interest in persuading countries to toughen their fiscal policies (some say that IMF stands for 'It's Mainly Fiscal'), they are not claiming that their medicine is painless.

Some people think they have seen the confidence fairy before. Often-cited examples are Denmark in 1982-86, Ireland in 1987-90 and Sweden in 1993-98. But in these cases the offsetting boost to income came not from a rise in public confidence, but from a depreciated exchange rate which raised net exports.

There are even reported sightings in Australia in the mid-1980s, where there was a very successful fiscal consolidation, with growth maintained. But the interpretation is disputed by those who see growth in this period being initially driven by recovery from the 1982 drought, then by the fall in the exchange rate (Keating's 'Banana Republic' period) and then pushed along at break-neck pace by financial deregulation and credit growth that ultimately led to the 'recession we had to have' in 1990.

The early Thatcher years have also been put forward as an example. No matter how necessary her reforms were to set the UK on an economically sustainable path, this period doesn't even remotely fit with the idea of expansionary pain-free budget austerity. Her initial measures stopped the economy in its tracks, not to regain its 1979 GDP level until 1984. Meanwhile, unemployment went from 1.5 million to 3.4 million in 1984; it was still over 2 million when she left office in 1990.

Thatcher's early policies certainly didn't produce an outpouring of confidence. She was the second-most unpopular prime minister in the post-World War II period. It's hard to image that you could get 364 economists to agree on anything, but they all signed a protest letter setting out their lack of confidence.

Her ultimate success was a result of her determination ('this lady is not for turning' and 'TINA: there is no alternative'). The Falklands victory saved her from electoral defeat in 1983, fortuitously giving her time to show that her policies could eventually work. She got no help from the confidence fairy.

Meanwhile, back in the present tense, the IMF sees 'an unmistakable need to restore fiscal sustainability through credible consolidation plans.' But with so many countries wanting to consolidate at the same time, they can't all get help from a depreciated exchange rate. The Greek attempt at austerity seems doomed. As they tighten, the economy falls deeper into a downward deficit spiral that no political system can survive. Sooner or later the Greeks will decide that it is less painful to renege on the debt, even if this means that they can't run a budget deficit, because no-one will lend to them. Locked into the euro (from which there is no easy escape), they can't get the benefit of a depreciation.

The less clear case is the UK austerity, which an earlier post described as 'courageous', in the Sir Humphrey sense. The UK can, at least, get help from a lower exchange rate. GDP is still well below the 2007 level. Perhaps, as in Mrs Thatcher's case, the economy will get beyond the short-term contractionary effect and start to grow again. Let's hope so.

History suggests that debt/GDP ratios are reduced by changing the denominator either through real growth or inflation. Cutting expenditure is hard work: even Mrs Thatcher couldn't stop budget expenditure from increasing; see this table of her time in office:

Photo courtesy of s~revenge