Austerity Principles, or How to Save an Economy in Crisis
Since the 2008 financial crisis, governments have experimented with just about every possible combination of fiscal and monetary policy. Some have pursued expansionary programs by borrowing heavily, cutting taxes and increasing spending. Others have gone the sackcloth-and-ashes route -- or were forced to -- by slashing spending and raising taxes. And some, the U.S. and the euro area included, have lurched from one strategy to another.
Adding to the miasma, the International Monetary Fund issued this week a surprisingly frank mea culpa on Greece, saying it shouldn’t have delayed that country’s debt restructuring or imposed fiscal contraction as a bailout condition. Meanwhile, exchanges between liberals and conservatives over flaws in the work of economists Carmen Reinhart and Kenneth Rogoff, who concluded that countries experience slower growth when government debt exceeds 90 percent of gross domestic product, are increasingly tart-tongued.
Nevertheless, after five years of experimentation, data collection and debate, the fog is lifting. It is now possible to lay down some broad principles for future downturns. Herewith:
-- There are no magic numbers. Studies, including some completed in recent weeks, show no correlation between debt today and growth tomorrow. And there certainly is no special number at which debt becomes crippling, such as the 90 percent debt-to-GDP ratio that some attribute to Reinhart and Rogoff. (For the record, they never said 90 percent was a magic number.)
-- Fiscal expansion works. When economies are weak, fiscal stimulus is the responsible policy. Governments that have used this tool have seen increases in demand, which in turn prevents more people from losing their jobs, adds to revenue and lowers government spending on social-welfare programs. Larry Summers, the former Treasury secretary and adviser to President Barack Obama, and University of California at Berkeley economist Brad DeLong showed that expansionary fiscal policy may even reduce, not increase, future debt burdens.
-- Fiscal contraction can backfire. If premature, spending cuts and tax increases can make deficits worse. Consider the U.S.’s budget sequestration, which on paper will reduce spending and the federal debt by $64 billion. This is equal to reducing the debt-to-GDP ratio by 0.39 percent. But sequestration will also reduce growth by 0.6 percentage point and lower tax revenue. In the end, as Summers told the Senate Budget Committee this week, it isn’t likely to improve debt-to-GDP at all.
Moreover, the idea of expansionary fiscal contraction is a contradiction. No place illustrates this better than the euro area, where austerity budgets have been imposed on debt-laden countries. The result is that the euro zone is mired in recession for the sixth consecutive quarter.
-- Currencies matter. One important factor is whether a country controls its currency. The U.K. could have improved its competitiveness, for example, by devaluing the pound to lift exports and discourage imports. It probably didn’t need to cut borrowing and spending as deeply as it has, and even the IMF is urging the U.K. to ease off the brakes. To dig out of decades-long deflation, Japan is essentially doing this -- driving down the yen to make its exports cheaper relative to others’ and pumping money into the economy.
Portugal and Spain, on the other hand, are in the euro area. They have no control over the currency’s value and therefore can’t use it to become more competitive.
-- Automatic stabilizers work. In the U.S., when it comes to fiscal policy in times of economic crisis, there isn’t much disagreement between the political parties. But if a separate debate over the proper size of government is allowed to intrude (as it has), the result is gridlock.
Policy makers should instead agree in advance to a system of automatic stabilizers that kick in during recessions. These include unemployment insurance extensions and relaxed eligibility standards for food stamps when the jobless rate exceeds, say, 6 percent. By the same token, lawmakers could agree to spend, say, 20 percent more on public works programs when unemployment increases. Automatic stabilizers offset about 20 percent of an economic shock after two years, according to research by Federal Reserve economists. The effect is even bigger in Europe, where automatic stabilizers are more prevalent.
Republicans shouldn’t care if the U.S. spends more this year and less next year so long as the permanent size of the government remains the same.
-- Culture matters. It is difficult for many Americans, not to mention most Germans, to swallow the central irony of financial crises: Although they are caused by overconfidence, overlending and overspending, they can be fixed only with more confidence, more lending and more spending. This doesn’t jibe with the belief that if parsimony is good at home, it’s also good for government.
When government borrowing subsides, voters are heartened. The widely publicized May 14 Congressional Budget Office report, which estimated that the fiscal 2013 deficit will decline to $642 billion, or 4 percent of GDP (down from 10 percent in 2009), may even be playing a role in recent consumer confidence, consumer spending and home-price improvements. It was only a few months ago that the CBO had projected a 2013 deficit of about $850 billion. Many economists had dolefully predicted an economic hiccup because of the payroll tax increase in January and deep budget cuts that started in March.
Elected officials should use cultural preferences to their advantage by explaining that debt can sometimes be useful, and then pushing hard for belt-tightening once recovery seems solid.
-- Austerity isn’t always bad. As we have said, excessive government borrowing can push up interest rates. If the rate exceeds the pace of GDP growth, the level of debt becomes a concern. Every country has its own point at which austerity becomes necessary to avoid rattling the bond markets. It’s best if governments don’t test where that line is.
Happily, the European Union, with 27 million unemployed, is backing away from austerity. Last week, it released seven countries from deficit targets and other budget obligations. Expansionary fiscal policy, mostly by Germany, should be the next move. Germany’s success at becoming a net saver and exporter was possible because of borrowing and importing by Italy, Spain and others. Until Germany allows its surplus to contract, the countries on Europe’s periphery won’t be able to shrink their borrowing.
The U.S., on the other hand, should be closing the large gap between projected tax revenue and spending on Medicare and Social Security. Congress has been doing precisely the opposite by focusing only on cutting discretionary spending, which will soon sink to the lowest level since the 1960s.
Retreating from misguided economic policies is always tough for elected leaders. Let’s hope that, after a lot of trial and error, pursuing the right course is getting easier.
To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at email@example.com.