Thursday, June 17, 2010

Fiscal austerity is not the answer

Sparked off by belt-tightening in Euro-zone, the calls for fiscal austerity elsewhere (especially the US) has grown louder. These voices (Paul Krugman calls them the "Pain Caucus") point to the burgeoning public debt burdens and the possible unraveling of inflationary expectations, and are now even advocating increasing interest rates.

The OECD set the pace in its latest Economic Outlook by suggesting that the US Fed raise the benchmark federal funds rate by 350 basis points by end-2011, even though its own forecast says that unemployment then will still be 8.4% and inflation under 1%. It also advocated an early exit from exceptional fiscal support, preferably now or atleast by 2011, in view of the "unfavorable government debt dynamics".

Raghuram Rajan has raised doubts about the effectiveness of accommodative fiscal and monetary policies and argues against both any more stimulus, including a jobs bill, and favors raising interest rates. He feels that such policies fuel inflationary pressures, endangers fiscal balance, creates asset bubbles not only in the US but in developed economies, and all this with little beneficial effects.(However, as this later post appears to indicate, his argument is for raising rates from ultra-low to low, so as to prevent the build-up of systemic-risk generating distortions)

Jeff Sachs points to the harmful effects of unsustainable debt burdens and calls for cutting spending. He argues that fiscal policy, at least in the US now, cannot credibly manage expectations to raise growth and lower unemployment.

And all this despite the fact that unemployment is still very high in all developed economies, decrease in unemployment rates far too slow to make any meaningful impact, and economic growth environment remains subdued. Moreover, both prices and long-term bond yields show no signs of inflationary expectations becoming entrenched. As Glenn Rudebusch pointed out in a superb recent article, even the doubling of the Fed’s balance sheet has had no discernible effect on long-run inflation expectations measured in the Survey of Professional Forecasters, consistent with Japan’s decade-long spell of price deflation.

Mark Thoma has this point to point answer to Raghuram Rajan's article, where he points to the CBO's assessment, consistent with a wide range of estimates, of the Obama administration's fiscal stimulus program. Brad De Long has this superb post on Jeff Sachs' argument by pointing to the lack of any signs of inflationary pressures building up and of prospects of higher interest rates that could result in "crowding-out" of private investments. Paul Krugman has this response to the OECD's recommendations.

Krugman has been amongst the most strongest critics of those calling for fiscal austerity and raising interest rates. As he and others have argued, the immediate macroeconomic problem is lack of demand, and not inflation or rising debt burden. Any contraction now, fiscal and monetary, at a time when some recovery is taking hold, is certain to end up stifling those green shoots of economic recovery. Instead of enacting contractionary policies, the objective now should be to tailor targeted stimulus policies that would specifically address the unemployment problem, boost aggregate demand and smoothen the recovery path.

And it is not as though any exit from stimulus is going to dramatically alter the fiscal balance of the US economy. Krugman points to a rough estimate (of US economy) that cutting spending by 1 percent of GDP would raise the unemployment rate by .75 percent compared with what it would otherwise be, yet reduce future debt by less than 0.5 percent of GDP.

Further, as the graphics below points out, the fiscal position has been compromised not by stimulus spending, which forms a surprisingly small share of the overall debt burden, but by other more important issues. The OECD's own estimates indicate that of the 35.5% increase in debt burdens across developed economies in the 2007-14 period shows, only 3.5 percentage points will come from fiscal stimulus, and the rest will come from other sources, most notably from revenue losses due to the drops in asset prices. At the current long-term inflation-protected securities rate of 1.75%, the long-term cost of servicing an extra trillion dollars of borrowing is $17.5 billion, or around 0.13 percent of GDP.

The IMF too estimates that of the almost 39 percentage points of GDP increase in the debt ratio in 2008-15 period, about two-thirds is explained by revenue weakness due to the adverse impact of recession. Interestingly, the IMF report estimates that the fiscal stimulus contributed to only one-tenth of the increase in debt.

In the US, the contributions to the increase in debt stock due to stimulus spending dwarfs those due to other fundamental factors like health care and social security spending. As the graphic below illustrates, the ARRA related deficits and debt stock is very small compared to those brought about by Bush era tax cuts and other aforementioned structural problems.

See also this post which puts the current stimulus spending in historical perspective.

In fact, lessons from a very recent precedent makes a strong case for continuing the expansionary policies. The Japanese government indulged in massive fiscal pump-priming throughout much of the nineties in response to the recession brought about by the property market crash in the early part of the decade. However, as the debt burdens grew, much like the present situation in countries like US, the Japanese government reacted by raising interest rates in 1998 and 1999. The economy, which was showing definite signs of recovery, plunged back to recession and deflation trap and a lost-decade ensued which carried well into the last decade.

The work of economists like Adam Posen have subsequently shown that the Japanese policy makers erred by raising rates mid-way and snuffing out recovery. The long-term fiscal costs of the entire process for Japan has been much larger than could have been the case without the mid-term contraction. The Americans and others could face much the same outcome if they exit prematurely from expansionary policies. See also Paul Krugman here highlighting the lack of any adverse inflationary impact in Japan due to its extraordinary expansion of the monetary base.

And a co-ordinated global fiscal austerity movement could be devastating for the world economy as a whole. As Krugman again points out with the case of Europe, the Mundell-Fleming model informs that "fiscal contraction in one country under floating exchange rates is in fact contractionary for the world as a whole. The reason is that fiscal contraction leads to lower interest rates, which leads to currency depreciation, which improves the trade balance of the contracting country — partly offsetting the fiscal contraction, but also imposing a contraction on the rest of the world." And now if the US too joins the fiscal contraction bandwagon, we will most certainly have global contraction all-round. Who will then act as the buyer of all these goods?

The supporters of fiscal austerity base their argument on the implicit premise that China and other emerging economies will provide the engines - either through their cheap exports (that would contribute to keeping domestic inflation in check) or by acting as robust markets for the developed economy exports (and thereby provide a boost for economic growth). However, as this and this shows, even China may not be immune to the inevitabilities of the economic growth cycle, and not be able to shoulder the burden. And even assuming that all these fears do not materialize, will China permit a large enough devaluation of the renminbi and will its consumers start loosening their purse-strings?

The parallels with Eurozone and invoking the threats of sovereign defaults there as a justification for fiscal austerity in the US may not be appropriate since the problems and prospects facing these economies are vastly different. The fundamental problem with Eurozone economies, like the PIIGS, are that in the absence of the conventional macroeconomic adjustment tools (currency devaluations, interest rate independence, stoking inflation etc), these economies are left with limited policy options to manage a reasonably painless transition to normalcy. See this, this, and this on the problems facing Euroland.

Finally, there is little evidence to show that fiscal austerity is, leave alone actually generate economic growth, even restore market confidence. Paul Krugman points to the examples of Canada and Ireland to show that it is wrong to conclude that fiscal austerity brought economic growth there. He also points to the recent example of Ireland's large fiscal austerity campaign, which does not appear to have had much real impact, as evidenced by the CDS spreads, in restoring market confidence.

In the absence of policies that boost aggregate demand and with a strong dose of fiscal austerity, the long-run fiscal and economics costs could far outstrip the short run fiscal benefits. As Krugman has said, the movement in favor "fiscal consolidation" can only be explained as a manifestation of the ideological position on fiscal discipline and a desire to be seen to be being fiscally tough.

Update 1 (20/6/2010)
Paul Krugman lists out the fiscal contraction in recent times and shows that they did not depress the economy since the "depressing effects were offset by huge moves into trade surplus and/or sharp declines in interest rates", both of which are impossible now.

Brad Delong shows how the adjustment of microeconomic imbalance is far different from that of macroeconomic imbalances.

Update 2 (21/6/2010)

Nouriel Roubini favors c-ordinated policy measures to answer to avoid a double-dip global recession - "deleveraging by households, governments, and financial institutions should be gradual—and supported by currency weakening—if we are to avoid a double-dip recession and a worsening of deflation. Countries that can still afford fiscal stimulus and need to reduce their savings and increase spending should contribute to the global current-account adjustment—through currency adjustments and expenditure increases—in order to prevent a global shortage of aggregate demand."

Paul Krugman writes, "Spend now, while the economy remains depressed; save later, once it has recovered".

See David Leonhardt on the perils of an early exit from monetary accommodation. Ben Bernanke himself is deeply aware of the huge challenge with unemployment, especially the nearly half share of those who have been unemployed for more than six months. See also this post on the consequences of the early exit in 1937, which led to the double-dip.

Update 3 (23/6/2010)

The new British coalition government unveiled the most severe package of spending cuts and tax increases since the early days of Margaret Thatcher’s era and the steepest fiscal spending reductions since the 1930s. They include average budget reductions of 25 percent for almost all government departments over the next five years, and will make Britain a leader among European countries, including Ireland, Greece and Spain, competing to show they can slash spending and appease investors worried about surging $1.4 trillion national debt.

It would cut the annual government deficit by nearly $180 billion over the next five years, shrinking Britain’s public sector and instituting tough reductions in public housing benefits, disability allowances and other previously sacrosanct aspects of the country’s $285 billion welfare budget. Also announced was a two-year wage freeze for all but the lowest paid among Britain’s six million public servants and a three-year freeze on benefits paid to parents for rearing children, in addition to new medical screening for people claiming disability benefits, part of a bid to cut $16 billion from the annual welfare budget.

A raft of tax increases were also announced - an increase next year to 20 percent from 17.5 percent in the value-added tax on most goods and services, and an increase in the capital gains tax, to a new high of 28 percent. At the same time, changes in income tax will remove nearly 900,000 of Britain’s poorest people from the income tax system altogether, and corporate taxes will also be reduced over a five-year period, to 24 percent from 28 percent.

Update 4 (25/6/2010)

Martin Wolf

"A reduction in the fiscal deficit must be offset by shifts in the private and foreign balances. If fiscal contraction is to be expansionary, net exports must increase and private spending must rise, or private savings [must] fall. Thus, experience of fiscal contraction is going to be very different when it occurs in a few small countries... when the financial sector is in good health... when the private sector is unindebted... when interest rates are high... when external demand is buoyant... and when real exchange rates depreciate sharply..."

Brad Delong wonders why it is so difficult to understand the merits of fiscal expansion, especially now.

Update 5 (29/6/2010)

In many ways Ireland is a classic example of the failure of the austerity medicine. Nearly two years ago, an economic collapse forced Ireland to cut public spending and raise taxes (by upto 20%), the type of austerity measures that financial markets are now pressing on most advanced industrial nations. Lacking stimulus money, the Irish economy shrank 7.1 percent last year and remains in recession, jblessness among its 4.5 million population is above 13 percent, and the ranks of the long-term unemployed — those out of work for a year or more — have more than doubled, to 5.3 percent. The budget went from surpluses in 2006 and 2007 to a staggering deficit of 14.3% of GDP last year, and continues to deteriorate and its once ultra-low debt could rise to 77 percent of GDP this year.

But the rewards to austerity remain invisible. Ireland’s risk spreads are worse than Spain’s, even though Ireland wasted no time on self-flagellation while Spain hesitated. It now pays a hefty three percentage points more than Germany on its benchmark bonds, in part because investors fear that the austerity program, by retarding growth and so far failing to reduce borrowing, will make it harder for Dublin to pay its bills rather than easier.

And all this despite Ireland being a classic case of growth by adopting neo-liberal policies. Its labor market is one of Europe’s most open and dynamic. After its last major recession in the 1980s, it lured knowledge-based multinationals like Intel and Microsoft — and now Facebook and Linked-In — with a 12.5% tax rate, giving Ireland one of the most export-dependent economies in the world, and massive investments in higher education.

Update 6 (30/6/2010)
David Leonhardt feels that relying on private sector to pull the world economy out of recession may fail. He draws attention to the thirties when between 1933 to 1937, the United States economy expanded more than 40 percent, but the recovery was still not durable enough to survive Roosevelt’s spending cuts and new Social Security tax. In 1938, the economy shrank 3.4 percent, and unemployment spiked.

Update 7 (6/10/2010)

Alberto F. Alesina and Silvia Ardagna examined the evidence on episodes of large stances in fiscal policy, both in cases of fiscal stimuli and in that of fiscal adjustments in OECD countries from 1970 to 2007, and found that

"Fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases. As for fiscal adjustments, those based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases. In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions."

Robert Barro argues against fiscal expansion describing the impact as "voodoo multipliers". Paul Krugman critiques Alesina and Ardagna study. And the IMF too finds flaws in Alesina study and argues that fiscal austerity during a crisis will only exacerbate the crisis. See a summary here.


Tracy W said...

I am not a macroeconomist, and it's been a few years since my macroeconomics lectures at university, so I don't follow some of your points.

1) Does it really matter how much of the debt problem is caused by fiscal stimulus versus how much by health spending, tax revenue falls, or social security spending? If governments are going to cut government spending, they should cut the lowest value-for-money forms of government spending first, whatever they may be. If supporting employment policies has higher value for money than some other forms of social security spending, or if governments can cut healthcare spending without affecting effectiveness (which appears possible in the USA given international comparisons) then would you disagree with fiscal austerity?

2) Can't central banks do quantitative easing to boost aggregate demand, as inflationary expectations are low?

3) What do interest rates tell us in this situation? Eg, let's take Riccardian Equivalence. If that's right then people expect taxes are going to rise in the future to pay back debts and the rising fiscal costs of healthcare spending and social security as the babyboomers retire. To hedge against that they buy government debt now, so at least they will get some money back from the taxes. Am I missing something? It's been a while.

4) You say "Any contraction now, fiscal and monetary, at a time when some recovery is taking hold, is certain to end up stifling those green shoots of economic recovery." I find the use of the word "certain" interesting. Why are you certain? Isn't this a repeat of the 391 economists who criticised Margaret Thatcher? What's changed in the last 30 years to justify the word "certain"?

5. You say: "And now if the US too joins the fiscal contraction bandwagon, we will most certainly have global contraction all-round. Who will then act as the buyer of all these goods?"
If no one wants to buy these goods, why should they be produced?

6. "As Krugman has said, the movement in favor "fiscal consolidation" can only be explained as a manifestation of the ideological position on fiscal discipline and a desire to be seen to be being fiscally tough. "

This is the sort of thing that Krugman says that lowers my opinion of him.

gulzar said...

thanks Tracy for those comments

1. the value-for-money analysis is fine with me, and should be the basis for spending decisions at all times. in the prevailing conditions, the short-run costs of deficits will be more than off-set by the medium-term benefits from recovery. simultaneously, if the US government can take measures to reform (not exactly "cut") health care spending (which it should in the US), then there is nothing like that. but that looks unlikely as seen by the wrangle with even pushing through the health care reform bill.

2. central banks can and should do QE to boost AD, as I have argued elsewhere (through purchases of long-term securities to lower the long-term interest rate expectations).

3. again the issue is one of trade-offs. ricardian equivalence is sure to be present in the minds of consumers and businesses. but the costs of fiscal austerity now are likely to be much larger - contraction now will lower tax revenues, depress both consumption and business investment, and push the economy into a depression (weak economy and a deflationary spiral). in any case, the relative share of the fiscal stimuluses is very small compared to the more critical issues like health care, social security etc.

in any case, the key to getting the greatest bang for thee spending buck is to get money into the hands of people who are likely to spend it than save it.

4. the conditions now are vastly different now from then. unlike then, monetary policy has lost traction due to the zero-bound, the financial markets are frozen due to the fears of defaults and counter-party risks, household balance sheets are in a mess, and external anchors of growth like exports are not available given the coupled nature of the Great Recession.

see Paul Krugman's answer to such examples here

5. agree with you on the specific point, but only in isolation.

on a general note, the dip in demand is the problem. for a couple of decades now, we have been witnessing an unprecedented consumption boom, and all of a sudden the Great recession has taken hold, and the consequences are there to see. the impact has been most deeply felt by the most vulnerable lower middle class and the poor, who have been laid-off and have been left without incomes to pay off their home mortgages and credit card/student loan debts.

an economy has to generate enough traction to keep this workforce employed. if not these products, something else... that is what the free-market was supposed to ensure. but since that is not happening, and will not happen as long the conditions persist, it makes great sense for the government to step in and generate some temporary demand with stimulus spending and get the economy back to normalcy as quickly as possible.

hope this works fine