What's at stake: The euro zone strategy to cut deficits has come under increasing strain from slowing economies, gyrating financial markets and electoral setbacks. Last year, we wrote a review on expansionary fiscal contraction that underscored the differing views between European policymakers and the vast majority of academics; especially after an IMF study deconstructed earlier studies on the growth impact of fiscal contractions. We come back to this issue, not only because it is again the hot topic of the day, but also to take stock of some of the new arguments that have been put forward in this debate.
The disconnect between academic research and the beliefs of policymakers
Christina Romer has a new essay about what we have learned about fiscal policy over the last few years where she draws two lessons main lessons: that fiscal policy matters in the short run, and that large, persistent deficits are ultimately very costly. These lessons are certainly not novel. To a large degree, the experience of the past few years has just solidified or amplified what we already knew (or should have known). But, the implications that flow from these lessons are at odds with much of what we see going on with policy.
Jacob Funk Kirkegaard argues that like it or not, fiscal austerity has to precede fiscal solidarity. Just because top euro area policymakers succumbed to promises of what my colleague John Williamson, in another context, once dubbed an “immaculate transfer” does not mean they are all imbeciles or members of the hardcore cult of austerity presided over by retired Bundesbankers. The reality is more nuanced. Fiscal consolidation today should be viewed as a political down payment by countries seeking guarantees from German taxpayers. It would be wonderful and much easier if a cooperative solution were available free of moral hazard. But few are so blessed in the real world. That is why the fiscal austerity and debt and deficit rules under way are important. The new EU fiscal surveillance packages in the so-called Six-Pack (consisting of five new regulations and one directive), the Two-Pack (the two new regulations under discussion), the Fiscal Compact Treaty, and the austerity in Spain and elsewhere might appear to be doing senseless damage to short-term macro-economic growth. But these steps make sense as laying out a path to new and necessary institutions to sustain the euro area.
Simon Wren Lewis notes that the degree of austerity imposed is, however, radical as the recent agreements are imposing tougher measures than the US or the UK, while it budgetary position of the euro area as a whole is more favourable.
The pace of consolidation, signaling, and the source of risk premia
As a benchmark, if financial markets are rational it should not matter when we generate income, only that it will eventually materialize. If fiscal multipliers are large, this results in recommendations to bias policy towards longer-term reforms while reducing short-term spending cuts. Pontus Rendahl makes this point on Voxeu. He argues that the fiscal multiplier can easily exceed one irrespective of the mode of financing when the economy is in a liquidity trap, there is high unemployment, and when unemployment is persistent.
However, one argument in favor of quick reduction of deficits might still be that quick spending cuts act as a signaling device. Simon Wren-Lewis argues that one reason why government might default is a political inability to cut spending or raise taxes enough to get the primary budget balance into surplus. Governments can demonstrate that they do have that ability by cutting the deficit rapidly now. Since governments are prone to short-termism, the incentives to default can also peak during short periods of high-indebtedness. Fast reduction of high risk-premia can then be necessary to reduce the probability of default.
An important factor when considering the optimal pace of consolidation is the source of risk premium on government debt. If the dominant factor in driving market perceptions of sovereign risk is short-term fiscal policy, reducing debt in the short term is more effective than reducing it in the longer term. But if the perception of sovereign risk is driven by the existence of multiple equilibriums in debt markets – as argued by Paul de Grauwe or Jonathan Portes – the obvious and direct way to deal with this issue is to provide explicit or implicit guarantees – either through the introduction of Eurobonds or aggressive intervention by the ECB (for more on these issues see our reviews on the ECB as a lender of last resort to sovereigns and eurobonds).
Chasing the wrong target and hysteresis
Wolfgang Münchau argues that there is a fundamental misunderstanding, in Brussels and Madrid, about the nature of the market panic about Spain. The markets are not panicking because Spain may miss the deficit target, but because Spain is trying to hit it. To hit these targets with a declining economy is not only bad economics, but physically impossible. He says a more credible strategy would be for Spain to focus on the banks first, forcing them to take losses, and consolidating them. That can only be done through the ESM, a task for which the Spanish government and the private sector are too weak. Eventually, such a programme could give rise to a bank resolution/supervision scheme. While the private sector deleveraging occurs, it would be unwise to engage in a simultaneous exercise of public sector retrenchment, which can wait a few years.
In a much debated paper presented at the Brookings Panel on Economic Activity, Brad DeLong and Lawrence Summers argue that under the very specific circumstances that characterize advanced economies today – MP @ the ZLB and high level of slack in the economy – temporary fiscal stimulus leads to an eventual reduction in the debt to GDP ratio for plausible levels of hysteresis. As today’s output level has long-lasting effects on future output, increasing deficits in times where the multipliers is big – Pascal Michaillat, Yuriy Gorodnichenko and Alan Auerbach for models and empirical evidence on how the multipliers evolve over the cycle, as well as our recent review of micro based studies – increasing in spending can be self-financing. The mirror image of self-financing deficits in the current environment is self-defeating fiscal consolidations.
Brad DeLong reacts to the latest attempt of Paul Krugman to estimate the impact of consolidation on the debt to GDP ratio. Paul Krugman argues that €1.00 of spending cuts in Europe produces only €0.40 of debt reduction relative to baseline and produces a €1.25 fall in production in the short run. Assuming a long-term real interest rate on secure government debt of 4%/year, that means that austerity now improves the government's long-run fiscal condition only if the η – the hysteresis shadow cast on future European output by the current downturn – for Europe right now is less than 0.014. If even 3 out of 200 workers laid off for a year during this depression never return to work and 3 out of every 200 machines not installed in factories are never installed, then austerity is a bad bet on pure fiscal-stability grounds alone.
Daniel Gros argues instead that even assuming that the impact of a permanent cut in public expenditure on demand and output is also permanent, the GDP reduction remains a one-off phenomenon, whereas the lower deficit continues to have a positive impact on the debt level year after year.
How to cope with external effects of fiscal policy?
To discuss the role of external effects, an interesting discussion has emerged on the policies an ideal European government would implement, to contrast this with the actual policies that individual countries are implementing, or with the policies that the six-pack is requiring. Simon Wren-Lewis argues that Europe needs a large stimulus relative to existing plans and a significant inflation differential between Germany and non-Germany. An ideal European government would raise inflation in Germany above the optimal level from the German national point of view.
Kantoos disagrees. An ideal European government would do three things that do not include fiscal stimulus in Germany. First, it would institute a monetary policy regime that does not narrow-mindedly focus on headline inflation but that does stabilize the nominal economy in Europe, ideally with a nominal GDP level target, targeting the forecast of course. Second, it would use all available tools (from macro-prudential regulation to monetary policy to fiscal rules) to manage the macroeconomy better and prevent regional booms and unsustainable sovereign debt. Third, it would conduct regional fiscal stabilization policy to support those regions that are in contraction despite the tools mentioned before, while at the same time forcing the countries to conduct the necessary reforms.
Is restructuring of household debt an alterbative?
Robert Skidelsky argues that in the Eurozone, both lenders and borrowers would be better off from a comprehensive debt cancelation. So would citizens whose livelihoods are being destroyed by governments’ desperate attempts to de-leverage. Rather than waiting to get rid of debt through bankruptcies, governments should “mandate debt forgiveness.”
In a very interesting interview with Mike Konczal on balance sheet recessions, Amir Sufi argues that we should at least try debt forgiveness. We are about four years into this mess, and we still don’t have any sense what the elasticity of consumption would be with respect to principal forgiveness. The reason we don’t have that estimate is that there’s been no principal forgiveness government programs. Of all that has been allocated, there’s been virtually nothing allocated to principal reduction to see if it works. I’m not willing to come out and say principal forgiveness will solve all of our problems. But at the very least, shouldn’t we have some basic idea of how responsive spending of highly indebted households would be to principal forgiveness? We’ve tried a ridiculous number of things in terms of government policy during this downturn: fiscal stimulus, homebuyer tax rebates, cash for clunkers, etc. Can’t we at least give principal forgiveness a chance, even if it is on a very small scale?
For more on all of these issues, the required reading is, as usual, the IMF Fiscal Monitor.
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