The international debate on the wisdom of fiscal austerity has being heating up. Since the onset of the crisis, the consensus seems to have gone through different stages: initially there was widespread support for fiscal stimulus, followed by concerns that fiscal policy needed to tighten as debt to GDP ratios rose in many countries to worrying levels, followed more recently by concern that fiscal policies may tighten too much given the persistence of the crisis-induced recessions.
A useful aspect of the recent debate is greater differentiation between countries facing serious sovereign creditworthiness challenges and those that do not. Countries facing immediate creditworthiness problems face a dilemma: fiscal tightening tends to further weaken the real economy; but allowing deficits and debt to stay on a higher path further weakens creditworthiness. The fiscal council has been grappling with this dilemma in its first two reports (see here and here).
Drawing on recent work with a number of co-authors, Giancarlo Corsetti provides a useful framework in this VOX piece for thinking about the dilemma. He makes the important point that the appropriate fiscal stance can be quite different for countries facing a large market risk premium (e.g. Ireland) and those that don’t (e.g. the UK). Countries facing a large risk premium face a dilemma in setting the fiscal stance between supporting demand and supporting creditworthiness – a trade off that is absent or at least much less pronounced in countries with low long-term bond yields. Corsetti’s framework has the additional element that increases in the sovereign risk premium can feed through to the risk premium facing the private sector though the entwining of bank and sovereign balance sheets. While he does not believe that this additional element makes fiscal contractions expansionary, it does tend to reduce fiscal multipliers. On the other hand, for countries not facing an elevated risk premium, multipliers are likely to be large for countries in deep recessions with policy interest rates constrained by the zero lower bound, suggesting the appropriateness of a more stimulative fiscal stance.
[S]ystematic anticyclical public spending is arguably desirable when policy credibility is not an issue. In the presence of a volatile market for government bonds, however, anticipation of anticyclical fiscal policy may not be helpful in ensuring macroeconomic stability. A prospective increase in spending in a recession may feed confidence crises by amplifying the anticipated deterioration of the budget associated with output contractions.
This possibility poses a dilemma for highly indebted countries. In light of the above considerations, countries with a large amount of debt may be well advised to tighten fiscal policies early, even if the beneficial effect of such action – prevention of a damaging crisis of confidence – will naturally be unobservable. From a probabilistic perspective, even a relatively unlikely negative outcome may be worth buying insurance against if its consequences are sufficiently momentous. In the current crisis, unfortunately, we know that such insurance does not come cheap.
As I noted in an earlier post, the recent paper by Brad DeLong and Larry Summers provides an important challenge to those who see a case for a more rapid fiscal adjustment. DeLong and Summers emphasise that current fiscal policies that slow the economy in the present can cast a long fiscal shadow through “hysteresis effects”. (Hysteresis effects here refer to effects of current output and employment levels on future output and employment through the inherited capital stock, inherited skills, inherited business/employment networks, etc.) In their model, it is possible for larger current fiscal contraction to worsen creditworthiness even if it leads to higher current deficit and debt ratios. As noted in the earlier post, DeLong and Summers recognise that the effects might be quite different for countries that already face a large default premium. Interestingly, however, this possibility is played down by Brad DeLong in his recent VOX column. Simon Wren-Lewis – who has provided a sustained argument for more relaxed fiscal stances in countries that are not facing market stress – provides a useful analysis of why the trade off would be different in the two types of countries. The argument comes down to incomplete information about the political capacity/willingness to make the necessary adjustments to avoid default.
One reason why government might default is a political inability to cut spending or raise taxes enough to get the primary budget balance into surplus. Governments can demonstrate that they do have that ability by cutting the deficit rapidly now. Promises to cut it in the future carry much less weight, and so as a result have less impact on the chance of default. Even when the primary balance is in surplus, a government may decide it is in the country’s best interest to default, because any damage to its reputation will be offset by the advantages of not having to cut spending or raise taxes still further to pay the interest on its debt. Once again, a government can demonstrate that it is not minded to do this by reducing its debt as quickly as possible.
In either case, default is less likely if debt follows the black line (austerity) rather than the red line (stimulus) [see post]. The markets are, quite rightly, not very interested in what happens into the medium term, because by that time default risk under either policy has all but disappeared.
This incomplete information problem may be heightened for countries within a monetary union with high debt to GDP ratios. As we have seen with experiences of Italy and Spain in the latter part of 2011, countries without their own central bank to act, in extremis, as lender of last resort to the government are susceptible to falling into a “bad expectations” equilibrium, whereby the perception of default risk (however formed) leads to high interest rates which leads to actual default risk.
The more differentiated treatments of the fiscal challenges facing different countries is a welcome development.