Saturday, July 16, 2011

The call for austerity - cure worsens the disease?

Carmen Reinhart and Ken Rogoff, the foremost historians of macroeconomic crises, have an excellent article in Bloomberg, where they express concern at the high debt overhang among developed economies.

Their magisterial examination of the history of financial crises and the relationship between growth and public liabilities found that when the debt-to-GDP ratio exceeds 90% in case of developed economies, it starts having adverse impact on long-term growth and macroeconomic stability. And this level has either been already breached or is fast approaching in most developed economies.

They cast doubt on the arguement of advocates of fiscal expansion, who claim that the ultra-low interest rates justify another round of stimulus despite the high public debt ratios. They argue that market interest rates can change dramatically in a few months with disastrous cascading consequences, whereas debt reduction takes years. Further, as the Japan example shows, high debt overhang, even without high interest rates, can hinder growth.

Though this analysis cannot be faulted, the implied solution - reining in debt with austerity and tax increases - is fraught with even bigger dangers. As I blogged earlier this week, expansionary fiscal consolidation holds limited promise. It contracts private domestic demand and the GDP. This should not come as a surprise since private consumption and business investment, which form the predominant source of growth in the absence of government spending, remains abysmally weak and shows no signs of revival. The only other remaining source of growth, external trade, too holds little promise and in any case cannot provide the thrust for recovering from such a bad crisis in case of large economies. See this and this.

Without private sector consumption and investment recovering, any contraction in government spending will only push the economy further down the recessionary path. The knock-on effect on the revenues side of the fiscal balance will be disastrous.

As has been well documented with the impact of the Great Recession on the US government deficit, the biggest concern during a recession is the reduction in government revenues and the resultant widening of fiscal deficits and debt-to-GDP ratios. In other words, the prescription turns out worsening the disease!

Paul Krugman has this concise response to the two most frequent arguments that deficits will drive up interest rates - government borrowing crowding out private borrowers and driving up rates, and fears of government's solvency frightening off investors and increasing the cost of borrowing.

Update 1 (17/7/2011)

The two big concerns for conservatives who advocate fiscal contraction are fears of high borrowing costs (bond-vigilantes) and high-inflation. These two concerns go against all standard macroeconomic models of economies stuck in slowdowns with interest rates at the zero-bound. Moreoever, they have been proved as wildly misplaced both from experience till date and from all available long-term forecasts.

In fact, quite to the contrary, all evidence points to a period of persistent low interest rates and low inflation (so much so that some economists, including the IMF, have called for raising the inflation target). This points to deflation, accompanied by Japan-style deep recession, as the greater danger now.

As to why the fiscal contraction story continues to grip the imagination of opinion makers, Paul Krugman points to Robert Kutter. They argue that this line of reasoning supports the interests of creditors, with significant exposure in bonds, loans, and cash. Mike Konczal calls it as "wealth and income defense". These rentiers have an interest in keeping inflation down and they positively benefit from a deflationary environment. Unfortunately, these run exactly opposite to the interests of workers and others.

Update 2 (3/9/2011)

Excellent op-ed in the Times which points out how Argentina, faced with similar high unemployment rate and a sovereign default, rebounded not with austerity but with massive fiscal expansion. For a start, the government intervened to keep the value of its currency low. It then increased taxes to finance a New Deal-like public works binge, increasing government spending to 25% GDP from 14% in 2003. It also strengthened its social safety net - the Universal Child Allowance, started in 2009 with support from both the ruling party and the opposition, gives 1.9 million low-income families a monthly stipend of about $42 per child, which helps increase consumption.

The Washington Post writes that a downturn in Europe deepened by choking off government revenues and increasing the demand for public services, could put struggling countries such as Spain and Italy at risk of missing the very deficit-reduction targets that budget cuts and other austerity measures were meant to achieve.

No comments: