Public debt stands at roughly 120% of GDP in advanced economies and about 65% in emerging markets (IMF 2024). Many governments now face a difficult challenge: how to mitigate concerns about fiscal sustainability, without triggering near-term output losses or reversing hard-won progress on containing extreme poverty and inequality.

In a recent paper (Bhasin and Loungani 2026a), we provide a comprehensive assessment of how the design features of fiscal consolidation packages (henceforth called ‘austerity’) shape their impact on two aggregate variables (output and unemployment) and two distributional variables (poverty and inequality). We consider several design features: instrument composition (tax-based versus expenditure-based austerity), size (consolidation as a percent of GDP), speed (gradual versus front-loaded), and timing (expansion versus recession; availability of monetary space). Some of these features have been emphasised in previous work. The importance of available monetary space was noted in Leigh et al. (2010). Giavazzi and Pagano (1990) argue that severe fiscal contractions can be expansionary because they are more likely to be perceived by the private sector as credible and bring about a decline in borrowing costs. To understand the impact of design features we use a dataset with over 200 austerity episodes in 17 advanced economies and 14 emerging markets over the period 1990–2023.

These episodes were identified by Adler et al. (2024) using the so-called ‘narrative’ approach, which requires manual screening of fiscal policy documents to reach a judgment on whether the government took deliberate policy actions to reduce deficits out of concern for fiscal sustainability. It is worth noting that Adler et al. (2024) provided the largest time and country coverage of austerity episodes but left an investigation of the effects of austerity to future research; our paper fills this gap.

The ‘narrative’ approach has become the industry standard for measuring austerity. Its use typically yields contractionary short-term effects of austerity (as in IMF 2010, and Fatás and Summers 2018). Other studies, such as Alesina and Ardagna (2010), which used the change in the cyclically adjusted fiscal balance as the measure of austerity, had found that austerity could sometimes be expansionary in the short run.

However, the narrative approach has also come in for criticism. Jordá and Taylor (2016) presented evidence that the episodes identified through this method were not exogenous and they also noted that the approach suffered from selectivity bias since countries did not choose to engage in austerity randomly. They proposed a new estimator to correct for these problems; these corrections did not change the conclusion that austerity was, typically, contractionary. In ongoing work (Bhasin and Loungani 2026b), we propose some econometric tweaks to the Jorda-Taylor estimator. In particular, we allow for a smooth transition function within their proposed framework to account for state-dependence.

Another limitation of the ‘narrative’ approach is that it is labour-intensive, as it requires careful reading of lengthy policy documents, and is not easily reproducible, as it is based on a judgment call about whether the government actions constitute austerity. In a separate paper (Bhasin and Loungani 2026c), we use large language models (LLMs) to identify austerity shocks. We find the LLM identifies more precise estimates of austerity’s macroeconomic impacts than traditional manual methods. Once again, to maintain comparability with the prior literature, the results below are not based on our LLM measures but on the Adler et al. (2024) measures of austerity.

Our results

Figure 1 shows the macroeconomic effects of austerity. The left panel shows the results for output while the right panel looks at unemployment. The baseline effect on output is contractionary. However, if the timing of consolidation is such that monetary space is available, there is a stark change: austerity is now expansionary! The diamond markers on the impulse responses indicate that the differences between the baseline and the alternate scenario are statistically significant. In other words, our results encompass the Alesina and Ardagna (2010) results and the IMF (2010) results.

The right panel shows that unemployment goes up in the aftermath of austerity in the baseline. But here again, a design feature — choosing tax-based instruments — can mitigate this effect. Consolidation that relies heavily on tax instruments produces near-zero unemployment effects through year two and unemployment actually declines at longer horizons. This result likely reflects the conjecture by Alesina and Giavazzi (2012) that expenditure-based consolidations rely more on direct public-sector layoffs, thereby raising unemployment immediately, whereas the impacts of tax-based consolidation on the labour market reflect slower indirect transmission through private demand.

In summary, Figure 1 shows that the short-term macroeconomic costs of austerity can be mitigated through careful design and timing.

Figure 1 Macroeconomic effects of austerity

Notes: We use the Jorda-Taylor (2016) estimator with Smooth Transition Function. Diamonds represent statistically significant differences in Average Treatment Effects at the 90% significance level.

Figure 2 shows the distributional consequences of austerity. The left panel shows the results for the Gini measure of inequality while the right panel has the results for the poverty headcount ratio (poverty rate). We find that inequality increases in the baseline results. But, as with output, availability of monetary space can overcome this adverse distributional impact, such that inequality actually declines. Once again, the diamond markers on the impulse responses show that this is a statistically significant deviation from the baseline.

The panel on the left shows that austerity increases poverty in the baseline results. However, design features, such as a more front-loaded adjustment – with its consequent impact on credibility and decline in interest rates – can overcome this adverse distributional impact.

To summarise, Figure 2 shows that, even the adverse distributional impacts of austerity emphasised by Ball et al. (2013), can be mitigated through design choices. 

Figure 2 Distributional effects of austerity

Notes: We use the Jorda-Taylor (2016) estimator. Diamonds represent statistically significant differences in Average Treatment Effects at the 90% significance level.

Figure 3 shows the impact of austerity on fiscal sustainability, measured here solely by the debt-to-GDP ratio. In the baseline, the debt-to-GDP ratio rises slightly before falling back. When monetary space is available, the debt-to-GDP ratio falls. However, not too much can be made of this finding, as the standard error bands are large (reflected in the absence of diamond markers on the impulse responses).

Figure 3 Impact of austerity on debt/GDP ratio

Notes: We use the Jorda-Taylor (2016) estimator with Smooth Transition Function.

Policy implications

Our results carry important policy implications.

The central finding is on the importance of coordination of monetary and fiscal policies. As shown above, by undertaking austerity when monetary space is available, the adverse impacts of austerity can be mitigated. We show in our paper that the effects of available monetary space are quantitatively as large as the effects of the timing of austerity (i.e. whether it is undertaken in expansion or recession) that Jorda and Taylor (2016) emphasised. Conversely, our results support the view that austerity is costly if undertaken when the economy is at the zero lower bound. Thus, our work generalises the findings of Miyamoto et al. (2018) for Japan on fiscal multipliers at the zero lower bound and is consistent with the arguments in Blanchard and Leigh (2013) about the euro area experience.

Our work also has implications for the policy choice of whether to implement austerity through tax-based or expenditure-based instruments. Alesina et al. (2019) have argued that expenditure-based austerity is significantly less costly than tax-based austerity. We revisit this conclusion with a broader set of austerity episodes and using the preferred Jorda-Taylor estimator. With these two changes, the sharp differences between tax-based and expenditure-based austerity that they saw start to blur. The policy implication of our findings is that, when consolidation does proceed, the choice between tax increases and spending cuts should be guided by social priorities rather than the expectation that one way of doing it is much less costly. Spending cuts protect income equality but cost jobs; tax increases preserve employment but compress incomes at the top less effectively. However, our results suggest that these instrument-level trade-offs on how to consolidate are quantitatively less important than the decision of when to consolidate.

Our results are likely to be particularly relevant for policymakers in emerging markets and developing economies, who face pressure from markets to maintain fiscal sustainability, but would prefer to do so without sacrificing hard-won progress on eradicating extreme poverty and inequality. Our evidence suggests that through careful design and monetary-fiscal coordination, countries can keep fiscal buffers from eroding, while limiting setbacks to such development goals. Austerity need not be a blunt instrument.

References

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