A commentary in the VoxEU Debate on the Global Crisis – Has austerity gone too far?
Posted by: Richard Wood, 14 April 2012
Contributors to the austerity debate have all made important observations. However, there seems to be a presumption in the contributions to date that policy decisions should be taken in a conventional bond financed budget deficit regime. This column identifies an alternative fiscal and monetary policy framework that would provide a basis for growth without raising public debt further.
A budget deficit, in and of itself, does not raise public debt. The main source of the spiralling levels of public debt in Europe is the issuance of new government bonds by periphery governments to finance their on-going budget deficits. If the issuance of new government bonds ceased, and the on-going deficits were financed directly by printing new money, then public debt would stop rising.
The current strategy adopted in the Eurozone countries could be characterised in its simplest terms as follows:
• Monetary policy is used to print new money to buy up excessive levels of government bonds on issue whenever the interest rates on government bonds in periphery countries rise above a threshold level, say, 6 per cent. This is an entirely defensive strategy, which buys time. Going forward, any new issuance of government bonds in periphery countries ― to finance their forecast on-going deficits into the future ― will continually re-ignite the debt problem, and trigger the need for further bond purchases on the secondary market by the European Central Bank. The current monetary policy does nothing to extinguish the source of the debt fire.
• Fiscal austerity policy aims, inter alia, to lower public spending and raise taxation as a means to lower the magnitude of the fiscal deficit, and eventually provide for fiscal surpluses. By lowering the magnitude of the fiscal deficit there will be smaller upward movements in public debt.
The main problem with this strategy is that this basic aim of the austerity policy is not being achieved, because austerity lowers growth or causes recession/depression, and as output weakens then tax revenues decline and certain public expenditure is increased. As a consequence, the budget deficit is higher than it might otherwise be, and the upward climb in public debt is perpetuated. This basic observation, and the underlying arithmetic, has been reflected in contributions to this debate.
Deep austerity would also result in internal deflation ― falling output, incomes and prices ― and, thereby, work over a long drawn out period to improve the international competitiveness of periphery countries. But deep austerity is not the only way to achieve lower wages and prices: that could be achieved much more efficiently by prices and incomes policies in periphery countries (in the absence of austerity).
Under an alternative approach monetary policy could be used to print the same amount of new money now being created by the European Central bank to buy up excess government bonds.
Fiscal policy could be adjusted to move away from deep fiscal austerity toward a relatively more expansionary, pro-growth fiscal stance.
The newly printed money could be redirected away from the task of buying excessive volumes of government bonds toward the task of financing the expected on-going budget deficits.
When achieved this approach would result in a stabilisation in levels of public debt. Public debt levels would no longer continue to spiral upward. The credit rating agencies would be under much less pressure to downgrade credit ratings of distressed periphery countries. The slide toward depression would be arrested. Pessimism and the current sense of hopelessness in periphery countries would be defused by the enhanced fiscal stimulus and the better prospects for the resumption of economic growth and employment.
In a monetary/exchange rate union the issuance of new money is usually the responsibility of the union’s central bank, in the case of the Eurozone, the European Central Bank.
For the European Central Bank to print new money, and provide it to the governments (Ministries of Finance) of periphery countries in order for them to finance their on-going budget deficits, it is necessary that the periphery governments issue new government bonds to the European Central Bank. This raises general government debt. Because this new debt is located in the central bank’s balance sheet, the credit rating agencies see that the new debt could be issued to the public at any time. Thus, even though the new debt is held on the European Central Bank’s balance sheet, it is recorded as what is colloquially termed ‘public debt’.
Consequently, in order to avoid this increase in public debt it would be necessary for the governments (Ministries of Finance, not Central Banks) of individual periphery countries to issue their own new money and directly finance their deficits with that new money. This could be achieved in a number of ways. For instance, the Greek government could print ‘new drachma’ and immediately exchange it at the European Central Bank for Euro. This would avoid drachma circulating alongside the Euro in Greece. Alternatively, of course, new drachma could be used to finance the budget deficit and thus enter into circulation, and be traded alongside the Euro. There are many instances in history, and currently, where two currencies are in circulation simultaneously. There may be other options: the European Central Bank could conceivably licence the governments of periphery countries to print Euro.
The current monetary and fiscal policy strategy operating in the Eurozone does not address the underlying problem forcing countries toward default, and to the splitting up of the Eurozone. This problem is represented by the new debt that will be created as periphery governments finance their on-going budget deficits by issuing new government bonds to the public. The current defensive strategy perpetuates the debt crisis, but tries to keep it under control. The costs include the massive distortion on the European Central bank’s balance sheet, falling output and rising unemployment.
The proposed defensive firewall does little to alter the underlying dynamics created by the conventional bond financing of budget deficits, and, if ever drawn upon, would raise new debt problems of immense proportions.
Andres, J and Domenech, R (2012), “The arithmetic of (excessive?) fiscal consolidation in Spain”, VoxEU.org, 7 April, 2012.
Corsetti, G (2012), “Has austerity gone too far?”, VoxEU.org, 2 April.
Delong, B (2012), “Spending cuts to improve confidence? No, the arithmetic goes the wrong way”, VoxEU.org, 6 April.
Wood, R (2012), “Delivering economic stimulus, addressing rising public debt and avoiding inflation”, Journal of Financial Economic Policy, Vol. 4 Iss: 1 pp 4-24.
Wood, R (2012), “What would Keynes recommend today”, Economonitor, 15 February 2012.
The views in this article are those of the author alone, and may not be shared by his employing agency.