Fiscal tightening is the watchword all across Europe. The measures adopted so far have not yet proved to be a cure-all for financial market concerns about debt sustainability. They have, however, coincided with renewed economic slowdown or even contraction. This brings into question the desirability of fiscal austerity.1
Two examples: Italy and Britain
How much of Italy’s slowdown is due to austerity and how much is due to the near debt-meltdown last summer? There is little doubt that the credit crunch that followed the sudden loss of credibility of Italian fiscal policy (whether or not justified by fundamentals) has a lot to do with the severe slowdown that this country is experiencing. The current fiscal tightening is arguably contractionary, but the alternative of not reacting to the credibility loss would have produced much worse consequences.
Things are more complex for the UK; it hasn’t lost credibility and it borrows at low interest rates. Does this mean UK policymakers are shooting themselves in the foot? Are they keeping the economy underemployed for years and thus destroying potential output with their austerity drive? Or, are they wisely forestalling a bond market rebellion like those seen on the continent that would prove much costlier?
Unfortunately we cannot know the answers definitively. Ten years from now some observers will deride the belief that the ‘confidence fairy’ would be summoned by belt-tightening; others will declare that their conservative fiscal attitude saved the countries from Greece’s fate. With only one economic path visible to historians and firm evidence in scant supply, we may never know.
A new Vox debate
The solution is a vigorous debate – which this column hopes to contribute to by launching a new Vox debate on the issue of austerity. There is a lot at stake in addressing the austerity question in the right way; which of the competing views is right matters greatly for policymaking and economic and social outcomes.
The terms of the debate are clear.
- The debate is not about the desirability of restoring safer fiscal positions after the large increase in gross and net public debt in the last few years.
This can be safely taken for granted.
- The question is whether governments should relent in their efforts to reduce deficits now, when the global economy is still weak, and policy credibility is far from granted.
- Under what circumstances would be wise to do so?
Budget policy vastly differs across countries.
- By and large, countries fall into three categories. At one extreme we have countries already facing a high and volatile risk premium in financial markets. At the other extreme we have countries with strong fiscal shoulders, actually enjoying a negative risk premium. A third category includes countries not facing a confidence crisis, yet with inherent vulnerabilities – a relatively high public debt, a fragile financial sector, and high unemployment.
- The question of how to ensure debt sustainability is vastly different across these.
- Not only specific conditions at country-level, but also policies at regional and global level may cause a given fiscal measure in a country to have vastly different effects.
- International considerations will complicate the analysis; a policy which may be perfectly viable and desirable for a country conditional on an international context, may not work in another, say, depending on the degree of international cooperation, especially in providing liquidity assistance and ‘firewalls’ against contagion.
Issues in front-loading austerity measures
Since 2008, the fiscal policy debate has gone through several phases.
- The first phase was dominated by a call for fiscal stimulus to avoid another Great Depression.
Thinking about deficit corrections in the future was seen as irrelevant, when not counterproductive, as it was feared that prospective consolidation plans would create additional uncertainty about the terms of the recovery.
- The second phase, from 2010 onward, saw the focus shift to fiscal consolidation as high public debt started to loom large.
This policy shift occurred despite a global economy that was not yet on a firm recovery path and monetary policy at or near the zero lower bound in many countries.
- The third phase may have begun; with weak growth, calls for austerity appear to have fallen out of fashion again.
The ranks of commentators who view austerity as potentially self-defeating have swollen (Cafiso and Cellini 2012, Cottarelli 2012, Gros 2011, Krugman 2012). These authors argue that the weak output growth caused by fiscal austerity may itself fuel market doubts about government solvency. Higher funding costs, combined with lower activity, might thus worsen the fiscal position, defeating the very purpose of the initial tightening measures. As observed by Olivier Blanchard, the “damned if you do it, damned if you don’t” attitude on fiscal austerity by financial markets may appear quite schizophrenic (Blanchard 2011).
New thinking: Self-defeating tightening in a liquidity trap
Recent contributions on the mechanism through which fiscal contraction in a liquidity trap is counterproductive provide an important change in perspective, relative to the initial debate.
A key point here is the recognition that much of the advanced world is currently in an unemployment and underemployment crisis. Destruction of jobs and firms today may be expected to have persistent effects on potential output in the future. These effects in turn translate into a fall in permanent income, and hence demand, today (see DeLong and Summers 2012 and Rendahl 2012).
In a liquidity trap, this creates a vicious self-reinforcing circle. Today’s unemployment creates expectations of low prospective employment, which in turn causes an endogenous drop in demand, reducing activity and raising unemployment even further. This vicious cycle may have little to do with price stickiness and expectations of deflation at the zero lower bound, an alternative mechanism early on stressed by Eggertsson and Woodford (2003) and more recently by Christiano et al (2011). Independent of deflation, the vicious cycle can be set in motion by expectations of lower income when shocks create persistent high underemployment. Theory suggests that this effect can be sizeable. The question is its empirical relevance.
The empirical evidence indeed weighs towards large multipliers at times of recession (Auerbach and Gorodnichenko 2010) or at times of crisis (Corsetti et al 2012), as opposed to very small multipliers when the economy operates close to potential and monetary policy is ‘unconstrained.’ In light of these results, it can be safely anticipated that the current fiscal contractions will exert a pronounced negative effect on output.
This is why, with a constrained monetary policy, there is little doubt that governments with a full and solid credibility capital should abstain from immediate fiscal tightening, while committing to future deficit reduction (the virtues of this policy are discussed by Corsetti et al 2010 and Werning 2012).
The problem is that, in the current context, promising future austerity alone may not be seen as sufficiently effective. Keeping market confident in the solvency of the country has indeed provided the main motivation for governments to respond to nervous financial markets with upfront tightening.
Credibility, sovereign risk, and macroeconomic instability
In a recent paper (Corsetti et al 2012), my co-authors and I highlight issues in stabilisation policy when the government is charged a sovereign-risk premium. The root of the problem is the empirical observation that sovereign risk adversely affects borrowing conditions in the broader economy. The correlation between public and private borrowing costs actually tends to become stronger during crises. Perhaps in a crisis period high correlation is simply the by-product of common recessionary shocks, affecting simultaneously but independently the balance sheets of the government and private firms. Most likely, however, it results from two-way causation.
In the current circumstances, there are good reasons to view causality as mostly flowing from public to private. First, in a fiscal crisis associated with large fluctuation in sovereign risk, financial intermediaries that suffer losses on their holdings of government bonds may slow down lending. Second, both financial and non-financial firms face higher risk of loss of outputs and profits due to tax hikes, increase in tariffs, disruptive strikes, and social unrest, not to mention lower domestic demand.
There are at least two implications of this ‘sovereign-risk channel of transmission’, linking public to private borrowing costs, for macroeconomic stability.
- First, if sovereign risk is already high, fiscal multipliers may be expected to be lower than in normal times.
The presence of a sovereign-risk channel changes the transmission of fiscal policy, particularly so when monetary policy is constrained (because, for example, policy rates are at the zero lower bound, or because the economy operates under fixed exchange rates). When sovereign risk is high, the negative effect on demand of a given contraction in government spending is offset to some extent by its positive impact on the sovereign-risk premium.
Some exercises we carry out suggest that, typically, consolidations will be contractionary in the short run. Only under extreme conditions does the model predict either negative multipliers (in line with the view of ‘expansionary fiscal austerity’) or counterproductive consolidations (in line with the view of ‘self-defeating austerity’). To the extent that budget cuts help reducing the risk premium, there is some loss in output, but not too large.
- Second, due to the sovereign-risk channel, highly indebted economies become vulnerable to self-fulfilling economic fluctuations.
In particular, an anticipated fall in output generates expectations of a deteriorating fiscal budget, causing markets to charge a higher risk premium on government debt. Through the sovereign-risk channel, this tends to raise private borrowing costs, depressing output and thus validating the initial pessimistic expectation.
Under such conditions, conventional wisdom about policymaking may not apply. In particular, systematic anticyclical public spending is arguably desirable when policy credibility is not an issue. In the presence of a volatile market for government bonds, however, anticipation of anticyclical fiscal policy may not be helpful in ensuring macroeconomic stability. A prospective increase in spending in a recession may feed confidence crises by amplifying the anticipated deterioration of the budget associated with output contractions.
Thorny issues for highly indebted countries
This possibility poses a dilemma for highly indebted countries. In light of the above considerations, countries with a large amount of debt may be well advised to tighten fiscal policies early, even if the beneficial effect of such action – prevention of a damaging crisis of confidence – will naturally be unobservable. From a probabilistic perspective, even a relatively unlikely negative outcome may be worth buying insurance against if its consequences are sufficiently momentous. In the current crisis, unfortunately, we know that such insurance does not come cheap.
The near-term costs of austerity mean we should keep thinking about alternatives, such as making commitments to future tightening more credible (eg entitlement-programme reforms).
However, the presence of a sovereign-risk channel also provides a strong argument for focusing on ways to limit the transmission of sovereign risk into private-sector borrowing conditions.
- Strongly capitalised banks are a key element here.
The ongoing efforts, coordinated by the European Banking Authority, to create extra capital buffers in European banks correspond to this logic.
- Another element is the attempt by monetary policymakers to offset high private borrowing costs (or a possible credit crunch) when sovereign-risk premium is high.
Normally, the scope to do this is exhausted when the policy rate hits the lower bound. Recent unconventional steps by the ECB, however, suggest that more is possible. The extension of three-year loans to banks, in particular, appears to have reduced funding strains, with positive knock-on effects for government bond markets.
- These arguments are especially strong for either countries already facing high interest rates in the market for their debt, or countries reasonably vulnerable to confidence crises.2 These countries would be ill advised to relax their fiscal stance.
- The arguments apply less to governments facing low interest rates.
The main issue is where to draw the line. Under what circumstances is it safe to postpone implementation of fiscal corrections?
There is an increasing tide in favour of reconsidering fiscal austerity programmes, in recognition of the persistent effects of underemployment of labour and capital on potential output. At the same time, however, it should be recognised that weak growth in countries facing precarious fiscal positions is not sufficient evidence against fiscal austerity. Where sovereign risk is high, fiscal tightening remains an important avenue to bring down deficits at a limited cost to economic activity, as risk premiums recede over time. In addition, fiscal austerity may well have important unobserved benefits, by preventing greater macroeconomic instability which tends to arise in the presence of high sovereign risk.
In light of these considerations, it is perhaps useful to move beyond the headlines of ‘expansionary contractions’ and ‘self-defeating fiscal austerity’. As a matter of fact, most governments face specific questions on how to reform their spending and taxation, rather than a general question of ‘how much’. Not only the intensity, but also and especially the content of upfront budget cuts currently contemplated in countries may be expected to have a first-order impact on the current recession.
Moreover, budget considerations are sensible insofar as in addition policymakers actively explore other ways to contain sovereign-risk premiums, or at least reduce their impact on broader economic conditions. Indeed, the big burden for the crisis countries in the Eurozone may be uncertainty of the common institutional and policy framework, favouring a solution for the debt overhang problem (a stock, not a flow problem), joint support to stem confidence crises and contain the transmission to the private sector (see Whelan 2012 on the ‘fiscal compact’). Fiscal and monetary interventions are sensible when directly targeted to these. They are counterproductive to the extent that they exacerbate the credibility problem and feed uncertainty. There is vast unexploited room for nonstandard and standard monetary interventions. But again, without a sense of direction, ie without a political and institutional development, the scope for the occasional action by existing institutions appears quite limited.
Auerbach, A and Y Gorodnichenko (2010), “Measuring the output responses to fiscal policy”, American Economic Journal, Economic Policy.
Blanchard O (2011), “2011 in review: Four hard truths”, IMF.org.
Cafiso, G and R Cellini (2012), “Fiscal consolidations for debt-to-GDP ratio containment? Maybe … but with much care”, VoxEU.org, 20 March.
Christiano, L, M Eichenbaum, and S Rebelo (2011), “When is the government spending multiplier large?”, Journal of Political Economy, 119(1):78-121.
Cottarelli, Carlo (2012), "Fiscal Adjustment: too much of a good thing?", VoxEU.org, 8 February.
Corsetti, Giancarlo, Keith Kuester, André Meier and Gernot Müller (2010), "Debt consolidation and fiscal stabilization of deep recessions", American Economic Review, 100:41-45, May.
Corsetti, Giancarlo, Keith Kuester, André Meier and Gernot Müller (2012), "Sovereign risk, fiscal policy and macroeconomic stability", IMF Working paper 12/33.
Corsetti, Giancarlo and Gernot Müller (2012), “Has austerity gone too far?”, VoxEU.org, 20 February.
DeLong, B and L Summers (2012), “Fiscal Policy in Depressed Economy”, Brookings, 20 March.
Eggertsson, GB and M Woodford (2003), “The zero interest-rate bound and optimal monetary policy”, Brookings Papers on Economic Activity, 1:139-211.
Eichengreen B and K O Rourke (2012), “A tale of two depressions redux”, VoxEU.org, 6 March.
Gros, D (2011), “Can austerity be self-defeating?”, VoxEU.org, 29 November.
Krugman, Paul (2012), "Blunder of Blunders", New York Times Blog, 22 March.
Rendahl P (2012), “Fiscal Policy in an Unemployment Crisis”, Cambridge University, 2012.
Sutherland, D, P Hoeller, and R Merola (2012), “Fiscal Consolidation: Part 1. How Much is Needed and How to Reduce Debt to a Prudent Level?”, OECD Economics Department Working Paper 932, OECD Publishing.
Werning, Iván (2012), “Managing a Liquidity Trap: Monetary and Fiscal Policy”, MIT mimeo
Whelan, Karl (2012), “Golden rule or golden straightjacket?”, VoxEU.org, 25 February.
2 For example, because of a high stock of public debt, small fiscal shoulders, and financial fragility.