Yes, Nations Can Spend Their Way Out of Recessions. Sometimes.

Central banks make it possible, or impossible.

Nations can rack up debt for stimulus ... if their central banks allow it.

Photographer: Krisztian Bocsi/Bloomberg

The great recession is just behind us, but economists are already busy debating whether rich countries have the tools to fight off the next slump.

With interest rates at rock bottom -- and unlikely to rise all that much in the coming years -- many believe governments will have to play a bigger role in a future crisis, raising spending to make up for any reduction in private consumption and investment.

A central question is therefore to what extent the high levels of debt racked up since 2008 will limit what governments can do. A new paper by Alan Auerbach and Yuriy Gorodnichenko of the University of California at Berkeley, presented at the Fed's Jackson Hole symposium last month, says this constraint may be less severe than some fear. But indebtedness does matter.

The case for government spending during economic slowdowns has been hotly debated for decades. John Maynard Keynes went as far as to suggest that during a recession governments should pay people to do meaningless tasks -- such as digging holes in the ground and then filling them up.

While most rich countries embraced Keynesian policies in the immediate aftermath of the crisis, in the early 2010s policy makers in Europe turned to the idea that austerity could be expansionary -- an idea associated with Alberto Alesina, a professor at Harvard University. Since then the consensus has shifted: Many economists including at the International Monetary Fund believe government spending during a crisis can help to restore growth without having an exceedingly detrimental effect on the public finances. Some think the stimulus may even pay for itself.

A separate question is whether all countries can afford to open their purse during a slump. Greece and Italy, for example, may find it harder to convince investors to fund higher deficits, given the nations' towering debts. And since all Group of 7 countries except Germany are now more indebted than they were before the crisis, the issue has become increasingly relevant for everyone.

Auerbach and Gorodnichenko respond to this question having assembled a large data set spanning to the last couple of years. Recent data is key because the levels of indebtedness rich countries now face have not been seen for decades. The researchers find that “even in countries with high public debt, the penalty for activist discretionary policy appears small.” In particular, while the cost of borrowing -- as measured by interest rates and credit default swaps -- increases more when debt is high than when it is low, the difference is small. When a government in a highly indebted country engages in fiscal stimulus, the ratio between debt and gross domestic product becomes higher permanently, but the increase is tiny.

The trouble is that the two researchers have to rely on a very small sample to identify this effect. This portion of their study is based on two observations per country: the years when debt levels are respectively highest and lowest. This limits the ability of their statistical model to determine the impact of spending increases on debt levels. It may also exclude some of the most interesting observations, for example at the peak of the financial crisis, when debt levels were lower than they are today.

Whether a high-debt country can engage in fiscal expansion during a slump will likely depend on a number of other factors. These include what exactly the government intends to spend the extra money on and whether there is a credible plan to cut spending in the future. Auerbach and Gorodnichenko acknowledge this risk when they say that “bridges to nowhere, ‘pet projects’ and other wasteful spending can outweigh any benefits of countercyclical fiscal policy.” The trouble for many high-debt countries is that they do not have much credibility that they will spend responsibly or cut when possible.

Most likely, the ability for high-debt countries to engage in fiscal stimulus during a bust may well depend on the central bank. The experience of the euro zone crisis shows that so long as the European Central Bank refused to provide a meaningful backstop to investors, weak sovereigns had severe troubles in borrowing from the market to sustain normal operations, let alone borrowing more to engage in fiscal stimulus. The ECB’s later commitment to purchase unlimited quantities of bonds from countries in difficulty pushed down interest rates dramatically: Only then could governments have realistically opted for a stimulus.

When the next recession hits, a greater role for fiscal policy would indeed be welcome. But we should be under no illusion: Whatever governments hope to do, central banks will continue to hold the key to a successful recovery.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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