More fiscal union, differentiated austerity

This column argues that recent discussions on self-defeating austerity neglect the monetary union dimension of fiscal policy. National austerity is unavoidable when financial pressure is high but should be gradual. Reversing austerity can have negative effects on the economy through the confidence channel in countries in difficulties. However, the negative effects of austerity call for temporary fiscal union, credible long term fiscal reforms, more public investment in countries with fiscal space and potentially some debt restructuring.

As the Irish budget is prepared for 2014, the austerity debate has re-emerged again. Some commentators claim that austerity is self-defeating. John McHale has produced a thoughtful piece discussing the different forms the self-defeating hypothesis can take. The strong from of the hypothesis claims that a reduction in spending would lead to an increase in the deficit. This hypothesis is clearly wrong as budget cuts throughout the periphery have led to decreases in the deficits, not increases.

A less strong from of the self-defeating hypothesis takes the view that a spending cut would increase the debt to GDP ratio due to the contractionary effect on GDP that the consolidation of the budget has. This effect is important. However, the key issue is to differentiate the short-run effects from the long run. Keeping the deficit permanently at 10 percent of GDP will inevitably lead to an explosion of debt and ultimately to insolvency. At the same time, consolidating too quickly when the fiscal multipliers are large has overly large negative effects on GDP. So the question of the speed of fiscal adjustment boils down to one of the time profile of the fiscal multipliers (see my previous blog post ).

The key result from this analysis is that fiscal adjustment should be gradual. Frontloading austerity will have too negative effects on output. Backloading adjustment to the future is a risky strategy and may lead to debt levels becoming non-sustainable. So the key is to define a gradual adjustment path and this path is different for every country depending on the adjustment need, the fiscal space and the likely reaction of GDP and yields to the adjustment.

One important dimension is the effect of fiscal adjustment on interest rates, in particular in countries under financial pressure. Austerity may increase interest rates due to the negative growth effects but financial markets may also demand austerity as a pre-condition for fiscal sustainability. The case of Portugal may offer a valuable lesson in this regard. On May 14, Portuguese bonds paid an interest rate of 5.5%. 3 weeks later with the resignation of Vitor Gaspar, the Portuguese finance minister, the yields increased to 6.5% and increasing temporarily above 7%. Markets clearly reacted very negatively to the emerging doubts about the fiscal adjustment programme in Portugal even though there may also be some doubt about the Portuguese willingness to stay in the euro area. This suggests that less fiscal austerity in countries with little fiscal space can lead to strong yield increases due to the increased likelihood of default and the lower debt sustainability.

A number of central implications follow from this picture.  

• First, giving up on fiscal adjustment altogether is a risky strategy. Financial markets may react significantly and this has negative implications for growth by making access to finance more costly and jeopardizing debt sustainability.
• Second, austerity is difficult to implement politically and socially. The years of austerity that may still be required in some of the euro area periphery countries may undermine political stability as recently seen in Portugal. Temporary outside support payments can be hugely beneficial to reduce this likelihood. This would mean advancing on the process of fiscal union more decisively. Certainly, the last summit with a programme of 6 billion for youth unemployed has been disappointing.[1] An alternative way of providing support may be through public and private debt restructuring. Besides OSI, Europe may have to make progress on a more orderly debt restructuring framework despite financial stability concerns.
• Thirdly, regaining fiscal space through long-term reforms that increase credibility is a winning strategy. It allows relaxing short-term fiscal austerity, has little negative effects on growth in the short run and increases debt sustainability. A credible pension reform, for example, can allow reducing the speed of fiscal adjustment in the short run.
• Finally, adjustment needs to be helped by better growth in the euro area as a whole. Euro area public investment is too low given the strong recession the eurozone is faced with. In particular countries with significant fiscal space should increase their public investment. 

[1] A central lesson from the theory of fiscal federalism is exactly this: at a state level, deficits are largely prohibited while the federal level would ensure temporary support to accommodate shocks (see for example Bill Oates research of the 1960s and my previous paper).