“… society, in its many dimensions, also adapts to higher persistent unemployment. When unemployment and the proportion of long-term unemployed becomes high, society is compelled, mostly through the political process, to make life bearable… through unemployment benefits, safety nets, real or pseudo-training programs, governments basically make sure that people do not starve. This is the normal response…. [I]t has very much the same effect as the factors I discussed earlier, namely that, by making unemployment more bearable, it increases the natural rate of unemployment…”
Olivier Blanchard (1997), “Comment on Ball, ‘Disinflation and the NAIRU’”, in Christina D. Romer and David Romer, eds., Reducing Inflation: Motivation and Strategy (Chicago: University of Chicago Press).
Olivier Blanchard is currently IMF Chief Economist.
“For sure, markets don’t like large debt and fiscal deficits, but they also don’t like low growth. Take the recent downgrades of several European countries. Were they purely the result of fiscal problems? No. Look at the words used by Standard & Poor’s: “a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.”
Some of our analytical work at the IMF makes this point clearly. It shows that lower debt ratios and deficits lead to lower interest rates on government bonds, but so too does faster short-term growth. So, when countries tighten fiscal policy and the economy slows, some of the gains from better fiscal fundamentals will be lost through lower growth. We also see some evidence of a nonlinear relationship between growth and sovereign bond spreads. Spreads are more likely to increase when growth is already low and the fiscal tightening is large. If growth falls enough as a result of a fiscal tightening, interest rates could actually rise as the deficit falls.”
Carlo Cottarelli (2012), “Fiscal Adjustment: Too Much of a Good Thing?” http://www.voxeu.org/index.php?q=node/7604
Carlo Cottarelli is currently Director of the Fiscal Affairs Department, IMF