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Austerity vs. Fiscal Stimulus: A False Dilemma?

Augusto Lopez-Claros's picture

The 2008-2009 global financial crisis led to a number of large–scale government interventions across the world. These included massive provisions of liquidity, the takeover of weak financial institutions, the extension of deposit insurance schemes, purchases by the government of troubled assets, bank recapitalization and, of course, packages of fiscal stimulus, sometimes of a scale not seen since World War II. Even the IMF, the world’s traditional guardian of sound public finance, came out strongly in favor of fiscal loosening, arguing through its managing director that “if there has ever been a time in modern economic history when fiscal policy and a fiscal stimulus should be used, it's now” and that it should take place “everywhere where it's possible. Everywhere where you have some room concerning debt sustainability. Everywhere where inflation is low enough not to risk having some kind of return of inflation, this effort has to be made".

One can argue whether the responses to the crisis were well-designed in particular countries, but there seems to be broad consensus that rapid international action on a number of fronts was necessary to prevent a 1930s-like depression with unforeseen global economic consequences. In the years that followed, public-debt levels rose rapidly, particularly among the advanced economies. Spain, for instance, saw its debt levels rise from under 37% of GDP in 2007 (well within the Maastricht criteria) to about 100% of GDP in 2014, according to IMF estimates.

Indeed, in many countries public indebtedness today stands at levels last seen at the end of World War II. These fiscal developments, however, have not prevented the emergence of an intense debate, particularly in Europe but also in the United States and other OECD countries, about the desirability of continued fiscal loosening, to mitigate the effects of weak economic growth and high levels of unemployment. These debates—largely academic at first—have intensified recently and have had political spillovers in some countries, with resigning ministers arguing against the constraints of “austerity,” as happened recently in France.

I would like to argue that this debate is largely a false one, in the sense that many countries, in fact, do not have the luxury of entering into a prolonged period of fiscal expansion, in the hopes of revitalizing anemic growth rates. Some form of fiscal consolidation, supported by other structural and institutional reforms, may be the only viable path in coming years. Here are three arguments in support of this claim.
  1. Reduced fiscal space. Many countries currently “suffering” the rigors of austerity face a sobering fiscal arithmetic over the next several years. To take an example: in 2013 Spain had a total financing need in excess of 20 percent of GDP. About two thirds of this consisted of maturing public debt and the rest was explained by a persistent budget deficit. The fiscal authorities, therefore, needed to access the bond markets on an annual basis to the tune of close to $300 billion (the financing figures for this year are broadly similar). This level of funding can be manageable in the context of a growing global economy with bullish investors and confident consumers. It becomes a huge risk if investors decide that the debt burden is unsustainable. In that scenario, interest rates will rise (sometimes with amazing speed) and the ability of the government to fund itself at reasonable cost will suddenly evaporate. With high debt levels, the room for fiscal maneuver is constrained by the mood of the international bond markets. To argue against austerity is fine, provided the authorities are certain that they will not lose the confidence of the markets in the process. With debt levels hovering around 100% of GDP that certainty is simply not there.  Not only are governments constrained in a fiscal stimulus, but with rising debt levels a growing share of spending will have to go to debt service, limiting expenditures on education, infrastructure and health and other areas that will improve competitiveness. Furthermore, not being a captive of the markets, means policymakers can be proactive about reforms, rather than reactive to a changing external environment.
  2. Medium-term pressures. One line of thinking argues that we should not worry excessively about debt levels now. In the United Kingdom and the United States, for instance, debt levels at the end of World War II were well in excess of 100% of GDP (in the UK substantially so). A combination of relatively good fiscal management, some inflation, and economic growth brought these levels down significantly by the mid-1970s. The problem with this argument is that the decades following the war had very favorable demographics, with substantial increases in the working age populations. Today we have the opposite problem: ageing populations. The cost of pensions, healthcare, and other social benefits is projected to rise rapidly over the next several decades. In the United States, for instance, 78 million people were born between 1946 and 1964 (the “baby boomers”) and this cohort started retiring in 2011. And this is not a problem only in rich industrial countries. China, Russia, Poland, Indonesia, Turkey, Mexico, to name a few, have an ageing population of their own. So, in coming years and decades, there will be fiscal pressures that were not present in the late 1940s and 1950s and that will significantly add to budgetary burdens and erode the ability of governments to simply “grow out of debt.”
  3. Unstable financial markets. There are credible economists (Nobel laureates even) who argue that the global financial system is inherently unstable, that there is no guarantee that it will not crash in the future as a result of abuse, misbehavior or other factors unrelated to those which caused the last crisis. Robert Shiller (2009), a leading observer of financial markets and one who issued repeated warnings about the real estate bubble in the United States, thinks that “capitalist economies, left to their own devices, without the balancing of governments, are essentially unstable.” There is no certainty, thus, that we could not yet again face what we saw in 2008 following the collapse of Lehman, or some variant thereof. What makes this a nightmare scenario is that the ability of governments to prevent an economic depression through a variety of interventions, such as those deployed in 2008-2009, will be very much a function of the health of their own finances. Absent this, what is left is the Latin American scenario of the 1980s: debt default and potentially very high inflation, except that this time around the impact would be global and highly destabilizing. The point here is that another financial crisis could put exactly the same kinds of pressures on budgets that we saw after 2008, but now the starting point, in terms of debt levels, is much worse.
It is misguided to think that if we could only relax budget rules and allow bigger deficits and correspondingly higher levels of debt, this will eliminate the need for the painful and long delayed reforms that highly indebted countries so desperately need. France, a member of the G7 and one of the world’s larger economies, has been running budget deficits without interruption for the past 40 consecutive years. In good times and bad times. Under conservative governments, and left-leaning ones. Along the way, public debt has more than quadrupled from under 21% of GDP in 1980 to close to 97% of GDP in 2014. To argue that, now, with weak economic growth, the solution is to be found in yet another episode of fiscal loosening is to profoundly misdiagnose the cause for the sluggish growth. Sustainable economic recovery—essential to successfully address the debt problem—will only come when governments implement reforms that will help remove supply-side barriers that have long undermined competitiveness and reduced potential growth. If anything, the global financial crisis has shown the high costs associated with delayed reforms.


Submitted by Burns on

International bond markets have shown that investors feel quite confident in buying debt from countries with their own sovereign currency so long as no other crisis is combined with the fiscal need (i.e. despot leader, conflict, etc). Even within the Euro-zone, once the ECB credibly promised to fulfill its responsibility as a lender of last resort within the Euro-zone, investor confidence came to mirror that of other markets for bonds from countries with sovereign currencies. Rates for France, Spain, etc dropped precipitously and look a lot like US, UK, etc.

What would lead Augusto Lopez-Claros (or anyone else) to believe that after 6 years about crying for structural reforms (aka extreme hardship for debtor nations and individuals) because inflation is just around the corner and the confidence of investors will fail at any moment? There is no evidence that this is the case.

Furthermore, the prescriptions suggested in this blog dismisses -- by way of avoidance -- the problem that proposed 'reforms' would actually move economies further away from their long-term potential in the short to medium term and thus compounds the long-run output-gap problem. For this to be a considered option, one would have to demonstrate the likelihood that moving further away from potential NOW would increase the area 'under the curve' over a meaningful timeframe. If the crossover is only somewhere in the distant future, it should be dismissed out of hand.

Submitted by Anonymous on

The path to a stable fiscal outlook is in energizing economic growth, unless you think that debt default is an option. Argentina tried it in 2001 and many others have experimented with it but it is a costly way to address debt problems. In order to move economies to a higher growth platform you need to do reforms that will improve competitiveness. For instance, you need to invest more in higher education and skills and less in wasteful energy subsidies. This need not be painful, and there is no need to think of reforms as necessarily leading to "extreme hardship" (to use your language). If designed properly, the growth payoff can be relatively quick. The debate about austerity vs. stimulus is false in the sense that it is distracting our attention from more urgent priorities. I am much more in favor of the Swedish approach: cautious fiscal policies and not forgetting that extravagance today has to be seen in the context of the needs of future generations. Augusto

Submitted by Greg Roberts on

Few people would argue against investments in higher education and worker skills, these are necessary reforms that have the potential to increase long-term competitiveness. But lets be clear, these are not the types of structural reforms pursued by countries such as Spain. Instead, the reforms came in the form of lower wages and reduced worker protections. Lets not forget that unemployment in Spain jumped from 8% at the beginning of the financial crisis to nearly 25% today. That’s suffering, not “suffering”.

Submitted by Sophia Kassidova on

Thank you for such a eloquent note on this big question. The arguments must be convinsing even for the neo Keynsian hard liners.

Submitted by Dirk Ehnts on

The euro zone countries have cut government spending since 2010, which has led to more public debt not less - if you look at government debt to GDP ratios, it is quite straightforward to understand that if GDP does not grow and there is a positive interest rate on sovereign debt then the ratio can only go up. You have to discuss economic growth, not budget deficits. Looking at euro zone sovereign bonds interest rate spreads, I cannot see how you can claim that there is a problem with higher debt. Spreads are coming down in all countries even though since 2010 government debt is on the rise. And Japan, with its government debt at 200+% of GDP, does not experience rising interest rates on sovereign bonds. It's all about the question whether your currency is sovereign (almost everyone) or not (euro zone). A good starting point to look into these issues is De Grauwe's paper:

Submitted by Anonymous on

Yes, I accept that being able to issue your own currency can help, particularly if others are willing to hold it as a store of value. This is the case for Japan and the United Kingdom, but not Argentina and Venezuela. Of course, I totally agree that the solution to the debt problem is economic growth, and perhaps a little more inflation. For most countries, debt default is not a practical option. It takes years to recover credit worthiness and is in general a messy way to eliminate a debt overhang. Yes, interest rates have been generally low, which has made higher debt levels seemingly sustainable. But this can change rapidly, in the middle of an external shock, or a homegrown financial crisis. In such cases, having fiscal space can make a huge difference for coping with the shock. This fiscal space has been greatly reduced in recent years and many countries are vulnerable. Incidentally, one country that managed the post 2008 crisis admirably well was Swedend. Debt to GDP ratios today are where they were in 2007, a relatively healthy 40%. But the Swedes actually believe in sustainable finances, in theory and in practice. For many other countries, that is an alien concept, left to be debated by the next government. Augusto

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