Two Tales of Adjustment: East Asian Lessons for European Growth

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Two Tales of Adjustment: East Asian Lessons for European Growth






       Anusha Chari                                                             Peter Blair Henry 

University of North Carolina at Chapel Hill              New York University 

National Bureau of Economic Research                    Brookings Institution 





January 2015 






In 2008, Euro-Zone governments instituted fiscal stimulus to counteract the shock of the Global 

Financial Crisis (GFC). In 2010, they changed tack and pursued consolidation. East Asia also 

implemented stimulus in response to its 1997–1998 financial crisis but, unlike Europe, continued 

fiscal expansion until growth recovered. The baseline difference between the average growth rate 

of the East Asian countries and the European Periphery/GIIPS prior to their respective crises was 

4.21 percentage points. This difference widens to 7.13 percentage points following the European 

pivot to austerity in region-specific crisis event time. Panel regressions confirm the statistical 

significance of this 2.92 percentage-point increase in the difference-in-difference estimate 

suggesting that more gradual fiscal consolidation in the GIIPS might have promoted stronger 







 We thank Pierre-Olivier Gourinchas, Ayhan Kose, Morris Goldstein, two anonymous referees, and participants at 

the IMF’s Fourteenth Jacques Polak Annual Research Conference for helpful comments and suggestions. Allison 

Cay Parker provided stellar editorial assistance. Anusha Chari: University of North Carolina at Chapel Hill and 


. Peter Blair Henry: Stern School of Business, New York University and Brookings 





When a country experiences a significant change in its macroeconomic circumstances, 

flexible policies can play an important role in mitigating the impact of the shock on output, 

employment, and other key measures of economic performance (Dornbusch and Fischer, 1987, 

Ch. 12). While there are generally a range of relevant policy options for leaders to consider in 

such scenarios, recent events in Europe and the United States have focused the collective 

attention of the economics profession on the role of fiscal policy. Specifically, the Great 

Recession triggered an acerbic debate over the issue of whether fiscal consolidation, colloquially 

known as “austerity,” has been helpful or harmful to the recovery of growth and employment in 

advanced economies. 

Conventional wisdom holds that fiscal expansion during a downturn can stimulate growth 

and return the economy to full employment, provided that debts are not so high as to preclude 

new borrowing. In contrast to this view, a small but influential literature documents that austerity 

actually spurs economic expansion when countries reduce their deficits through lower spending 

rather than higher taxes (Alesina and Perotti, 1995; Alesina and Ardagna, 2010). Given the 

extended slowdown in Europe following the onset of fiscal consolidation in 2010, however, and 

the relatively weak U.S. recovery in the aftermath of sequestration, the counterintuitive notion of 

expansionary austerity faces increasing skepticism. Recent research at the International 

Monetary Fund (IMF) reports a negative relationship between fiscal consolidation forecasts and 

subsequent forecast errors of GDP growth (Blanchard and Leigh, 2014). This evidence suggests 

that the IMF underestimated the size of fiscal multipliers with respect to the fiscal consolidation 

programs that were announced in Europe in early 2010. 

Despite mounting evidence in favor of Blanchard and Leigh, the austerity dispute 

remains unresolved in the academic community, and there is certainly no indication that the view 


of rapid fiscal consolidation as harmful to growth carries the day with policymakers in advanced 

countries (Jordà and Taylor, 2013). Given the inconclusive state of the debate, it is surprising 

that both intellectual camps continue to direct their analytical machinery exclusively at episodes 

where countries pursue fiscal consolidation, ignoring the wealth of information to be found in


comparing the economic performance of countries that pursue austerity with those that do not. 

In contrast to the previous literature on fiscal adjustment, this is precisely the approach 

we adopt in this paper. We compare and contrast the European policy response to the Global 

Financial Crisis of 2008–2009 with the Asian policy response to the East Asian Financial Crisis 

of 1997–1998 to conduct an experiment in which East Asia serves as the control group that 

allows us to 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 the policy 


Austerity apologists will claim that the slow recovery in Europe has little, if anything, to 

do with fiscal consolidation and is entirely consistent with the Reinhart and Rogoff (2009) 

finding that economic recoveries following financial-crisis-induced recessions are much slower 

than those caused by routine monetary tightening. Using the East Asian crisis countries as a 

control group has the advantage of allowing us to address this alternative explanation directly. 

Like Europe, East Asia suffered a financial-crisis-induced recession caused by a lack of 

regulatory oversight and excessive lending (especially in real estate), followed by a high 

incidence of non-performing loans, widespread failure of financial institutions, and a severe 

credit crunch. Also like Europe, the East Asian countries responded to their crisis by 

implementing a series of fiscal stimulus packages. In sharp contrast to Europe, however, the East 


Asian countries maintained a largely invariant level of fiscal stimulus with which they persisted 

until their economies achieved a sustained recovery. Europe’s pivot away from stimulus toward a 

starkly different policy stance in the midst of a crisis with very similar causes to the one in Asia 

enables us to view the trajectory of output in Asia as a proxy for what might have happened in 

the peripheral countries of Greece, Ireland, Italy, Portugal, and Spain (GIIPS) had Europe stayed 

the course with stimulus. 

The solid line in Figure 1, which plots the evolution of the GIIPS’ primary fiscal balance 

relative to the year of the crisis, tells the tale. In Years -4 through -1, the GIIPS ran average 

deficits of 2.3 percent of GDP, but the line is basically flat during that period, indicating that 

prior to the crisis they were engaged in neither fiscal expansion nor consolidation. The line dips 

in Year 0 when, in accordance with advice from the IMF, the GIIPS allowed their average 

primary deficit to increase to 5.55 percent of GDP—a fiscal expansion of 3.25 percentage points. 

Fiscal expansion continued in each of the next two years as the average deficit reached 13 

percent of GDP. The line spikes upward between Years 2 and 3, however, as the GIIPS complied 

with the European Commission and European Central Bank’s demand for smaller deficits and 

reduced their average primary balance from 13 percent to 7.7 percent of GDP in Year 3—a 5.3 

percentage-point consolidation—and to 6.1 percent of GDP in Year 4, a further consolidation of 

1.6 percentage points. 

Turning from fiscal policy to growth, the solid line in Figure 2 indicates that from -4 to -1 

the GIIPS grew by an average of 3.2 percent per year, whereas from 0 to 4 they have been 

contracting at an average annual rate of 1.7 percent—a decrease in growth of almost 5 

percentage points per year relative to their pre-crisis average. Instead of a “V” shaped recovery, 

Europe’s has been a “W” as it were—less the final upstroke. The correspondence between the 


components of this three-quarter “W” and the evolution of fiscal policy depicted in Figure 1 

provides strong prima facie evidence that the pivot from expansion to consolidation had a 

negative impact on economic recovery in the GIIPS. Although growth turned negative on impact 

and bottomed out at almost negative 5 percent in the first year after the crisis, Figure 2 shows 

that the pace of contraction between Years 1 and 2 slowed compared to the beginning of the 

crisis—a strong indicator that the fiscal expansion in Years 0 and 1 had, with a lag, the intended 

effect on economies that might otherwise have continued in free fall. Indeed, it is hard to resist 

the conclusion that the increased speed of economic contraction between Years 3 and 4—the so-

called double dip—was triggered by the large and rapid pivot to fiscal consolidation after Year 2. 

When the East Asian Financial Crisis hit in late 1997, the IMF prescribed austerity for the 

affected countries. The Fund changed course in April of 1998, however, because it realized that 

growth in the region was falling precipitously. As demonstrated by the dashed line in Figure 1, 

East Asian governments used the latitude provided by the IMF to pursue a policy of fiscal 

expansion. By allowing automatic stabilizers to take hold (e.g., the average primary balance in 

Asia went from a surplus of 1.8 percent of GDP in 1997 to a deficit of 1.8 percent in 1998) and, 

unlike their European counterparts, persisting with expansionary policy until economic activity 

rebounded, Asian leaders were able to ensure that the economic downturn, however severe, was 

a short-lived affair. As indicated by the dashed line in Figure 2, in the countries hit by the East 

Asian Crisis—Indonesia, Korea, Malaysia, and Thailand—the average growth rate of GDP fell 

from about 7 percent per year in the four years before the onset of the crisis to -9 percent upon 

impact. But GDP growth turned positive again within a year of the crisis, and the average growth 

rate of GDP during the four-year period following the crisis was about 5 percent—lower than the 

pre-crisis average but a strong performance by most standards. 


The difference in the speed of the economic recovery of the GIIPS and East Asia is 

especially interesting given that Figure 1 indicates that fiscal policy in the GIIPS over the entire 

episode from Year -1 to Year 4 was actually more expansionary than in East Asia. Whereas the 

expansion in the primary balance in both regions in Year 0 was about 3.3 percentage points of 

GDP, the GIIPS’ fiscal expansion of 5.7 percentage points in Year 1 and 1.8 percentage points in 

Year 2 was much larger than East Asia’s fiscal stimulus in those two years. 

This observation suggests that outcomes in the GIIPS would almost surely have been 

much worse had their initial stimulus not been so aggressive. It also points to an important lesson 

that Europe could take away from the East Asian experience: conditional on the size of the initial 

stimulus, a less variable and more persistent path of expansion by the GIIPS would likely have 

promoted a stronger recovery. That is to say, a more gradual fiscal consolidation in Years 3 and 

4 might have been more beneficial to growth. Indeed, the absolute magnitude of the GIIPS’ 5.3-

percentage-point consolidation in Year 3 was larger than the stimulus in Asia during any year 

following its crisis, and roughly half the size of the cumulative fiscal expansion in Europe in 

Years 0, 1, and 2. To use an imperfect, advanced-economy analogy, although the GIIPS still ran 

deficits in Years 3 and 4, the U.S. monetary policy equivalent of the GIIPS’ massive deficit 

reduction after 2010 would have been a sudden stop to quantitative easing. In addition to the 

impact that the GIIPS’ relative budget-tightening—fiscal tapering writ large—probably had on 

output through the standard effects on current consumption and investment, it also likely 

increased volatility and therefore uncertainty about the expected future path of fiscal policy. 

Greater policy uncertainty creates an incentive to delay major consumption and investment 

decisions thereby causing a further fall in output (Baker, Bloom, and Davis, 2013). 

While Figures 1 and 2 suggest that steady adherence to countercyclical fiscal policy by 


East Asian countries following their 1997

–1998 financial crisis helped generate a rapid and 

robust recovery and that the GIIPS would have been better off implementing a more measured 

decrease in the primary deficit, there are at least three 

reasons why these initial observations 

should be interpreted with caution.


First, the policy experiment we conduct is not a strict apples-to-apples comparison. 


East Asian Crisis began in the periphery of the world economy and never fully penetrated the 

core, so that 

continuing growth in the advanced economies could act as a buffer to support a 

quick, export-oriented recovery in Asia. In contrast, the 2008–2009 Global Financial Crisis 

originated in the core so that the GIIPS did not have a similar buffer to restore growth. 

It is 

therefore possible that the prolonged European slowdown is a product not of austerity, but rather 

of the GIIPS having been hit by a synchronous recession—one in which 10 or more of the 21 

advanced countries are in recession simultaneously. Data on the four such recessions that have 

occurred since

 1960 provide no support for the synchronicity hypothesis (see Section IVB), but 

core-driven external demand did play a central role in spurring a swift East Asian recovery. 

The role of exports in the Asian rebound reminds us that fiscal policy is just one of the 

stabilization tools available to policymakers confronted with a negative shock. The adjustment of 

prices—specifically the exchange rate—also played an important role in the rapid recovery of 

output in East Asia. Further, under the auspices of their IMF programs, the East Asian countries 

implemented far-reaching structural reforms ranging from the labor market to the financial 

sector. It is not obvious that Europe has pursued an agenda of productivity and competitiveness-

enhancing structural reforms with a similar sense of urgency (Lane, 2013). 


, in spite of the similarities 

that make the East Asia–Europe comparison so 

compelling, the two regions had nontrivial differences in their initial macroeconomic conditions. 


Although both experienced growth booms prior to their respective crises, the Asian countries had 

accumulated surpluses by running countercyclical fiscal policy, while the GIIPS took a largely 

pro-cyclical stance. The cumulative result of these surpluses was that Asian countries had much 

lower pre-crisis debt-to-GDP ratios and therefore a larger fiscal cushion with which to absorb the 

impact of their crisis than European countries did at the onset of the Great Recession.



While our results need to be interpreted with caution, they provide substantial evidence 

that fiscal consolidation in Europe exerted a powerful, negative impact on growth. We begin by 

computing a baseline GIIPS–East Asia growth difference as the average growth rate of the GIIPS 

during the four years prior to their crisis (3.17 percent), minus the average growth rate for the 

East Asian countries in the four years prior to theirs (7.38 percent). The resulting difference

equal to -4.21 percentage points, is our basis of comparison. If fiscal austerity had no impact on 

output then the GIIPS–East Asia growth difference after the pivot should be economically and 

statistically indistinguishable from what it was before the pivot. This is not the case. Across the 

board, t-tests of differences in differences confirm the simple visual story of Figures 1 and 2. 

For example, the GIIPS–East Asia growth difference widens to -7.13 percentage points in 

the post-pivot period, and the 2.92 percentage-point difference in difference is statistically 

significant at the 1 percent confidence level. T-tests of differences in differences on 

unemployment are consistent with the growth results, and all of our results are robust to 

alternative time frames for the pre- and post-pivot windows. 

Moreover, panel regression estimates that control for country-fixed effects, changes in 



 In contrast to previous episodes, disciplined fiscal policy leading up to this crisis gave emerging-market countries 

room to pursue countercyclical fiscal policies during the crisis, and this made a substantial difference (Blanchard, 

2013). The evidence on initial conditions in our paper suggests that East Asian countries consistently ran fiscal 

surpluses in the run-up to the crisis and had much lower debt-to-GDP ratios on the eve of their crisis in comparison 

to the GIIPS countries, giving them greater fiscal space to pursue countercyclical policies during the crisis. 



exchange rates, and differences in debt-to-GDP ratios corroborate that the change in fiscal stance 

from stimulus to austerity had a negative and statistically significant impact on real GDP growth 

in Europe. In East Asia, the impact of fiscal policy is evident on impact during and following the 

crisis, and had a statistically significant effect on real GDP growth in the post-crisis period.


The remainder of the paper proceeds as follows: Section I describes the data and 

methods. Section II presents t-tests of means of differences in deficits and growth rates within 

Europe and Asia over time. Section III constructs measures of differences in differences between 

Europe and Asia over time and tests whether these differences in differences are statistically 

significant. Section IV presents the results of panel regressions that explore whether changes in 

deficits across countries are useful predictors of cross-country changes in growth rates; it also 

explores the robustness of our results to changes in exchange rates, differences in debt-to-GDP 

ratios, and synchronous recessions. Section V concludes. 


I. Data and Methodology 

Our principle data sources are the IMF’s World Economic Outlook (April 2013) and its 

International Financial Statistics (IFS) database. The WEO provides numerous time series related 

to output, unemployment, government debt, and deficits. Other data for variables such as 

exchange rates, prices, wages, and productivity come from the IFS database, the Bank of 

International Settlements, and Eurostat. The appendix presents the exact definition of each 

variable and the name of the database from which it came. The sample period is 1990–2012. The 

primary country panel includes the four countries hit by the East Asian Crisis—Indonesia, 

Korea, Malaysia, and Thailand—and the peripheral countries of the original Euro Zone: Greece, 


Ireland, Italy, Portugal, and Spain.


 The formal estimations also consider a wider Asian sample 

that includes China, India, Hong Kong, Philippines, Singapore, and Taiwan, plus the remaining 

(original) Euro Zone countries of Austria, Belgium, Denmark, Finland, France, Germany, 

Luxembourg, the Netherlands, and Sweden. The sample also includes the United Kingdom. 

For the European countries, the WEO includes a measure of the government structural 

balance also known as the cyclically adjusted primary balance (CAPB). The CAPB is widely 

used as a measure of the government’s fiscal stance because it filters out changes in the fiscal 

deficit caused by fluctuations in the business cycle, thereby isolating the impact of discretionary 

changes in policy (Alesina and Perotti, 1995; Alesina and Ardagna 2010; Guajardo, Leigh and 

Pescatori, 2011; Jordà and Taylor, 2013). While our examination of fiscal policy begins with the 

primary balance (Figure 1), because it conveys the extent to which East Asian and European 

governments permitted automatic stabilizers to work during their crises, it is also critical to 

understand whether their intentional fiscal policy stances tell a consistent story about the abrupt 

pivot to consolidation in Europe versus moderate and persistent stimulus in East Asia. The 

CAPB is therefore central to our analysis. Since the WEO does not provide data on the CAPB for 

the East Asian economies until after the year 2000—too late to be useful in an analysis of the 

impact of their crisis—we constructed the CAPB going back to 1993 for Indonesia, 1990 for 

Malaysia, 1995 for South Korea, and 1995 for Thailand following the methodology prescribed 

by Fedelino, Ivanova, and Horton (2009).   

Briefly, the cyclically adjusted primary balance is: 




 The original Euro Zone refers to member countries that adopted the Euro before physical notes and coins were first 

introduced in January 2002. 



The first term on the right-hand side is the cyclically adjusted component of government 

revenues where   is nominal primary revenue

 is potential output,   is actual output, and   

is the elasticity of revenue with respect to the output gap. The second term is the cyclically 

adjusted component of government expenditures where   is nominal government expenditure 

and   is the elasticity of government expenditures with respect to the output gap. Fedelino, 

Ivanova, and Horton (2009) suggest that if the elasticity of revenue equals one (i.e., revenues are 

perfectly correlated with the business cycle) and expenditure elasticity is equal to zero (i.e., 

expenditures are not affected by the cycle), the cyclically adjusted primary balance becomes: 

Since measures of potential output 

 were also missing from the WEO database, we followed 

the IMF’s methodology and computed estimates of trend output using a Hodrick-Prescott filter 

with a smoothing parameter of 100. We used this measure of potential output to compute 

estimates of the output gap for the East Asian countries as well as the cyclically adjusted primary 

balance as a percentage of potential output (or GGSB_NPGDP in the WEO). 

Figure 3, which plots the evolution of the CAPB as a percentage of potential GDP in East 

Asia and Europe, reinforces the fundamental point that Asia and Europe took significantly 

different approaches to fiscal policy. The dashed line shows that East Asia pursued a fiscal 

policy stance in the midst and immediate aftermath of the crisis that was consistently neutral to 

expansionary. The solid line indicates that the GIIPS’ pivot to fiscal consolidation actually began 

after Year 1—a year earlier than one would conclude from just looking at the primary balance.  

The graph confirms the robustness of our pivot-versus-stay-the-course narrative, but it is time to 

move from visual evidence to statistical significance. 




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