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Current Issues in Economics
Policy response
Austerity vs. stimulus
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Policy response
Austerity vs. stimulus
• Six years after the global crisis erupted, the world’s
mature economies – especially the Eurozone – find
themselves with shockingly fragile economies.
• Have the austerity programs adopted by countries
since 2011 been cutting too much and too soon? Has
austerity triggered a self-defeating ‘doom loop’
whereby budget cuts and tax rises widen deficits by
throwing economies into tailspins?
• Is spending more by increasing public debt a solution?
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Policy response
Austerity vs. stimulus
• In US crisis originated from private financial sector but
with monetary (low interest rates) and mortgage
guarantees encouragement from the state.
• In Europe, causality mostly flowing from public to
private.
– 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.
– 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.
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Policy response
Austerity vs. stimulus
Hope of soft landing
• The ability to finance macroeconomic imbalances
through easy foreign borrowing allowed US and
countries of Euro zone to postpone tough policy
choices. Investors’ appetite for public debt that
turned out to be toxic provided one ready source
of external funding of the deficit.
• At the same time, countries with current account
surpluses (first of all China) faced minimal
pressures to adjust.
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Policy response
Austerity vs. stimulus
• The world is seized by a debate between fiscal austerity
and fiscal stimulus. Opponents of austerity worry about
contractionary effects on the economy. Opponents of
stimulus worry about indebtedness and moral hazard
• A procyclical fiscal policy piles on the spending and tax cuts
on top of booms, but reduces spending and raises taxes in
response to downturns. Budgetary profligacy during
expansion; austerity in recessions. Procyclical fiscal policy is
destabilising, because it worsens the dangers of
overheating, inflation, and asset bubbles during the booms
and exacerbates the losses in output and employment
during the recessions. In other words, a procyclical fiscal
policy magnifies the severity of the business cycle.
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Policy response
Austerity vs. stimulus
• Austerity describes policies used by governments
to reduce budget deficits during adverse
economic conditions. These policies may include
spending cuts, tax increases, or a mixture of the
two.
• Austerity policies to demonstrate governments'
fiscal discipline to their creditor and credit rating
agencies by bringing revenues closer to
expenditures; they may also be politically or
ideologically driven
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Policy response
Austerity vs. stimulus
• Stimulus refers to attempts to use monetary or fiscal
policyto stimulate the economy.
• Fiscal stimulus refers to increasing government
consumption or transfers or lowering taxes. Effectively
this means increasing the rate of growth of public debt
except that particularly Keynesians often assume that
the stimulus will cause sufficient economic growth to
fills that gap partially or completely.
• Monetary stimulus refers to lowering interest rates,
quantitative easing, or other ways of increasing the
amount of money or credit.
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Policy response
Austerity vs. stimulus
• Quantitative easing (QE) is an unconventional
monetary policy used by a central bank to stimulate an
economy when standard monetary policy has become
ineffective.
• A central bank implements quantitative easing by
buying specified amounts of financial assets from
commercial banks and other private institutions, thus
raising the prices of those financial assets and lowering
their yield, while simultaneously increasing the
monetary base.
• This differs from the more usual policy of buying or
selling short-term government bonds in order to keep
interbank interest rates at a specified target value.
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Policy response
Austerity vs. stimulus
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Policy response
Austerity vs. stimulus
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Policy response
Austerity vs. stimulus
• According to IMF, the quantitative easing policies
undertaken by the central banks of the major
developed countries since the beginning of the
late-2000s financial crisis have contributed to the
reduction in systemic risks
• The QE policies also contributed to the
improvements in market confidence and the
bottoming-out of the recession in the second half
of 2009.
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Policy response
Austerity vs. stimulus
• Today policymakers, whether they actually recognize it
or not, are caught in a debate between the thinking of
two great economists: Keynes and Friedrich Hayek. The
practical implications of this intellectual debate shape
action in terms of choosing either more austerity or
stimulus.
• Keynes - unemployment and idle resources caused by
a lack of effective demand
• Hayek, they stem from a previous, unsustainable
episode of easy money and artificially low interest
rates
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Policy response
Austerity vs. stimulus
What economists could know?
• In 2003, Robert Lucas of the University of
Chicago, in his presidential address to the
American Economic Association, declared that
the “central problem of depression-prevention
has been solved, for all practical purposes, and
has in fact been solved for many decades.”
• The Queen of England asks economists –
“Why did nobody notice?”
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Policy response
Austerity vs. stimulus
Disappointing institutional response
• Official discussion of the risks posed by large global
imbalances intensified in the fall of 2003 as G7 officials
pressured Japan and (verbally) China to reduce their
intervention purchases of dollars.
• At the G7 and IMF meeting in Dubai in 2003, the United
States also pledged to take steps to promote national
saving, while Europe committed to raise productivity.
• Later, in February 2004, the G7 finance ministers and
central bank governors asserted clearly that, along with
structural policies to enhance growth, “sound fiscal policies
over the medium-term are key to addressing global current
account imbalances.”
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Policy response
Austerity vs. stimulus
• In 2009 many countries rolled out big
packages of tax cuts and extra spending in the
hope of buoying growth.
• This stimulus amounted to 2% of GDP on
average among the members of the G20 club
of big economies
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Policy response
Austerity vs. stimulus
Multiplier effect
• Sceptics - it would be low, and that neither stimulus nor austerity
would have much effect on output or jobs. Stimulus simply absorbs
resources that would otherwise have been used by private firms.
Firms and households would probably save their share of the
proceeds, rather than bolster the economy by spending them, since
they would assume that it was temporary.
• Optimists -ith unemployment high and private demand for loans
low, there was little risk that the government would “crowd out”
private activity. Indeed, with indebted households forced by falling
asset prices to pay off loans quickly, a boost to incomes from a fiscal
stimulus would speed the financial adjustment, and thus generate a
faster recovery.
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Policy response
Austerity vs. stimulus
• Supporters of stimulus looked to the ideas of Keynes. Depression occurs
when too many people want to save and too few to invest, then resources
(including workers) fall idle. Firms and families might save too much
because of financial uncertainty or because they are rushing to
“deleverage”—to reduce the ratio of their debts to their assets.
• When there is slack in the economy, fiscal stimulus can be particularly
powerful thanks to a “multiplier” effect. A dollar spent building a railway,
for example, might go to the wages of a construction worker. He then
spends the extra income on groceries, enriching a shopkeeper, who in turn
goes shopping himself and so on
• In normal times central banks would try to spur growth by adjusting
interest rates to discourage saving and encourage borrowing. Yet by early
2009 most central banks had reduced their main interest rates almost to
zero, without the desired result. Over indebtedness, have been preventing
people from borrowing as much as they would like, whatever the interest
rate.
• Governments needed to make up for firms and families, by borrowing and
spending more (or taxing less) to put excess savings to work.
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Policy response
Austerity vs. stimulus
• In many cases, austerity measures have been
associated by critics with a decline in living
standards and have led to popular protest.
• The financial crisis—particularly the austerity
package put forth by the EU and the IMF—was
met with great anger by the Greek public,
leading to riots and social unrest
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Policy response
Austerity vs. stimulus
IMF U-turn
Most recently, however, capitalism has been
characterized by “excess”—in risk-taking, leverage,
opacity, complexity, and compensation. It led to
massive destruction of value. It has also been
associated with high unemployment, rising social
tensions, and growing political disillusion – all of
this happening in the wake of the Great Recession.
Christine Lagarde Managing Director, International
Monetary Fund, 2014
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Policy response
Austerity vs. stimulus
Supporters of austerity - fiscal stimulus is needed most when governments
already have extra costs to bear. From 2007 to 2010 rich countries saw the
ratio of their gross sovereign debt to GDP spike from 74% to 101% on average.
British public debt jumped from just 44% of GDP to 79%, while America’s
leapt from 66% of GDP to 98%. Greece’s soared by 40 percentage points, to
148% of GDP
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Policy response
Austerity vs. stimulus
Germany the main supporter of austerity and enemy of
stimulus
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Policy response
Austerity vs. stimulus
•
Is austerity good or bad? It is a wrong question. When an economy
is in a boom, the government should run a surplus; other times,
when in recession, it should run a deficit.
• Many politicians in the developed countries live by procyclicality.
They argue against fiscal discipline when the economy is strong,
only to become deficit hawks when the economy is weak.
• Historically, developing countries used to be the ones where
dysfunctional political systems produced procyclical fiscal policies
during 1960-99. But things have changed. Remarkably, during the
decade 2000-10, about a third of emerging market governments
took advantage of the boom years 2003-7 to strengthen their
budget positions, saving up for a rainy day. They were thus in a
good position to ease up when the global recession hit them in
2008-9.
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Policy response
Austerity vs. stimulus
• Today, global economy faces both lack of
demand as consumers continue to reduce
debt as well as structural barriers on the
supply side due to lack of investment in
human and physical capital, which has limited
economic potential
• There has been a misallocation of capital due
to a period of artificially low interest rates.
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Policy response
Austerity vs. stimulus
Need for balanced approach
• IMF managing director in August 2011, "For the advanced
economies, there is an unmistakable need to restore fiscal
sustainability through credible consolidation plans. At the
same time we know that slamming on the brakes too
quickly will hurt the recovery and worsen job prospects. So
fiscal adjustment must resolve the conundrum of being
neither too fast nor too slow. Shaping a fiscal consolidation
is all about timing. What is needed is a dual focus on
medium-term consolidation and short-term support for
growth. That may sound contradictory, but the two are
mutually reinforcing. Decisions on future consolidation,
tackling the issues that will bring sustained fiscal
improvement, create space in the near term for policies
that support growth.
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Policy response
Austerity vs. stimulus
Stimulus temptation
As growth returned in 2010 some leaders
argued that it was time to trim public spending.
Others worried that the recovery was too fragile
to permit any hint of austerity.
There was no question that “fiscal
consolidation” would eventually be necessary,
but much dispute about when it should start.
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Policy response
Austerity vs. stimulus
Deeper roots
• The debate is not about the need for fiscal discipline.
• In advanced countries, with an aging population and
rising healthcare costs, the large expansion of debt due
to the crisis is an unwelcome addition to the fiscal
burden, and requires a convincing policy response.
• Rather, the debate is about the extent to which
spending cuts and tax hikes in the short run are
desirable and effective in containing the prospect of
sovereign risk crises.
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Policy response
Austerity vs. stimulus
• Strategies that involve short-term stimulus with
longer-term austerity are not mutually exclusive.
• Steps can be taken in the present that will reduce
future spending, such as on pensions by reducing
cost of living adjustments or raising the
retirement age for younger members of the
population,
• while at the same time creating short-term
spending or tax cut programs to stimulate the
economy to create jobs.
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Policy response
Austerity vs. stimulus
Lesson from history (that there are no lessons)
• For the first time since the 1930s, the world is suffering from a
persistent lack of adequate demand; people just aren’t spending
enough to make use of the productive capacity we have. This was
supposed to be a solved problem, one that may have bedeviled our
grandfathers but wasn’t going to come back.
• Economists thought we had macroeconomic policymaking under
control. Demand management was assigned to technocrats at
independent central banks while fiscal policy focused on long-run
issues. In the face of large, sustained shocks, however, it turns out
that this system breaks down. On one side, central banks are
constrained both by the zero lower bound—the fact that interest
rates can’t go negative—and by concerns over the size of their
balance sheets. On the other, fiscal policy, far from helping, quickly
began making things worse. Krugman
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