The Theoretical and Empirical Failures of Fiscal Austerity Policies
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Transcript of The Theoretical and Empirical Failures of Fiscal Austerity Policies
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Pact of 1997 (adherence to which was a condition of European currency union membership)
(BBC News - Business, 2012). From this it is already clear that the label of universal fiscal
profligacy is unwarranted and that the rapid escalation of debt levels was symptomatic to the
financial crisis (Tyson, 2012)
Figure 1 (Lane, 2012)
Structural defects and imbalances between the central European core and the southern
European periphery account for the rapid increase in debt post-financial crisis. Theintroduction of the European Monetary Union in 1999 saw a convergence of bond yields
(determined by their perceived risk) across member states. The potential benefits of the
currency union (and the elimination of exchange and inflation risks) fed investor confidence
and led to a reduction of sovereign bond yields from the periphery to align with those of the
core (European Central Bank, 2012).
The periphery capitalized on the now plentiful cheap credit, a fact which caused housing
bubbles in both Spain and Ireland (attributable for the most part to private sector borrowing)
and decidedly loose fiscal policy in Portugal and Greece. This fragile system, pushed over
the edge by the financial crisis, led to a major reassessment among investors of the
sustainability of rapid credit growth and large ... deficits. Concerns then turned to European
sovereign debt, when, in 2009, many countries reported unexpectedly high deficits as a result
of recession-induced dwindling tax revenues (Lane, 2012, pp. 56-58). What followed were a
rapid deterioration of bond yields and the spiralling of sovereign debt.
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Figure 2 analyses the initial effects of, and the Euro zone reaction to, the recession with the
IS-LM framework1. For the purposes of this analysis the price level and inflation are fixed.
The initial equilibrium is at output (y1) and (i(1)), the recession caused a dramatic decrease in
consumption and autonomous investment and hence demand (Z). This decrease in output
(spurred on by the multiplier effect) then induced a leftward shift in the IS-curve causing
equilibrium to shift to [i(2), (y2)] . The effect of the recession was mildly offset by some
expansionary fiscal policy, though the initial scope for which (given the cash starved nature
of EMU member economies and their mounting debt) is minimal. To give an idea of the
extent of the immediate effects of the recession, during the second quarter of 2008 alone,
Eurozone GDP fell by 0.1%. The effect over the entire duration of the recession is of course
more pronounced (Finfacts , 2008).
Figure 2
1 The Is-curve herein contained is an aggregate Is, the horizontal summation of individual member countries.
Although the EMU represents a monetary union (and hence can only have one LM curve), it is comprised of
different member states that follow independent fiscal policies). Nonetheless, the scope of this analysis is suchthat it considers LM and Is curves for the EMU as a whole, that is to say it studies the aggregate effect(irrespective of whether some Is curves shift leftwards/ rightwards in the process).
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From mid 2008, the European central bank reacted to the financial crisis with expansionary
monetary policy. The effects of such a policy, whereby the European central bank drastically
reduced short term interest rates, through the provision of extensive Euro-denominated
liquidity, are given by shifts in the LM curve (Lane, 2012, p. 55). The shift from LM (1) to
LM (2) results in the equilibrium given by (y4). However, due to the already low interest rate
level, a shift of the LM further than LM3 will induce neither changes in the interest rates nor
an increase in output. This point is given by X, the ineffective point, after which
expansionary monetary policy becomes futile (a Keynesian liquidity trap) (Krugman, 2011).
Figure 3 shows the steady decline in interest rates as a result of the continued monetary
expansion. The table shows the most recent results from mid 2011, note that at present, the
interest rates sit at around 0.25%, very close to 0.
Figure 3 (European Central Bank, 2012)
Given the prevailing situation in Europe a demand-deficiency-induced recession (low
output and consequently high unemployment) and spiralling debt (and debt-to-GDP ratios)
compounded by lower tax revenues (as a result of the recession) the role of austerity fiscal
policy seem dubious. The theoretical justification for such policy is based on the empirical
work by Alberto Alesina (2010) who, after a historical analysis of the effects of deficit
reduction/ austerity (that is to say, situations where government reduces spending or increases
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taxation) on GDP, concluded that not all fiscal adjustments cause recessions (Alesina,
2010). The basic theory is summarised by Figure 4. When analysed from a traditional
Keynesian perspective, within the framework of the IS-LM model, we see that austerity (or
deficit reduction) results in the short-run in a decrease in output and interest rates via a
leftward shift of the IS curve (the decrease in government spending/ increase in taxation
results in a decrease in demand and through the multiplier effect, a decrease in output) 2.
Alesina posited that consumers and investors would perceive the governments return to
fiscal prudence and their move to bring debt under control, as a sign of future economic
stability. This would then cause an increase in consumer and investor confidence and a
rightward shift of the IS curve (movement I). Having revived demand, the economy would
then be better placed to make movement J, towards the initial equilibrium and then further to
such an extent such that full employment is restored. Given this evidence, it would seem that
the only course of action for the cash-strapped and heavily indebted Eurozone would indeed
be fiscal austerity. Not only would it restore demand but it would greatly improve budget
balances and aid in the reduction of the debt to GDP ratio. Van der Veen (2012) notes thatincreased levels of confidence would not be the only possible expansionary effect
(theoretically). Given that EMU countries cannot individually devalue their countries
(because they are part of a monetary union), austerity policies may contribute to internal
devaluation. The deficit reduction and ensuing lower output and higher unemployment could
put downward pressure on real wages, making exports more competitive and inducing
recovery (Veen, 2012, pp. 20-21).
2 Though interest rates decrease and as a result, investment increases, the increase in investment does not offset
the negative effect of the initial decrease in government spending.
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Figure 4
Shiller (2012) argues that Alesinas historical analysis is flawed statistically because it
doesnt take into account the possibility of reverse causality and because it fails to distinguish
between the economic intent of governments appearing to go through austerity. A
government who, in expectation of an increase in domestic demand, takes on a more frugal
fiscal policy but whose cutbacks are insufficient to slow down the expected increase in
domestic demand, may appear to have increased performance under austerity. These
anomalies result from our inability to control for all variables in complex macroeconomic
situations.
Empirically, austerity seems not to have cured but exacerbated the European sovereign debt
crisis. Analysis of the reductions in government spending, controlling for intent, that is to say
cuts in government spending not due to the decrease in tax revenue (as a result of the
recession) show that austerity has lead to reductions in GDP growth rate (from 1, 06% in the
first quarter of 2008 to 0.97% in the last quarter of 2011) and has been accompanied by mild
increases in the debt to GDP ratio (controlling for decreases in tax revenue as a result of the
recession) (Shambaugh, 2012, pp. 29, 54). This resonates with the historical analysis of
Guardo et al. who (controlling for intent) found that austerity programs weaken both
consumption and investment (Shiller, 2012). The contractionary effects of austerity in the
EMU culminated in the downgrading of the credit rating of several member states in January
2012 (Veen, 2012, p. 21).
The fundamental premise of austerity is not a cruel or misguided one, sovereign debt needs to
be serviced as quickly as possible lest it spiral farther out of control- economies that too are
highly leveraged sit evermore precariously on the brink of financial crisis. But as Stiglitz
(2012) points out, growth and confidence (all essential to the long and short term
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Figure 5 (BBC News - Business, 2012)
These structural imbalances do, ironically, have the capacity to improve the situation in the
Eurozone. Debt to GDP ratios can be reduced if there is sustained economic growth. Growth
would revive demand, increase tax revenues and reduce deficits and debt (Veen, 2012, p. 22).
Moreover broad-based structural reforms within Europe are crucial to ensure that conditions
encourage growth. Germany, given its relative economic stability and unparalleled cheap
borrowing costs has the ability to finance the investment and development required for the
GDP growth to take place in the rest of Europe. One particular target for such investment is
education, ensuring that human capital, typically negatively affected by sustained periods of
unemployment, does not atrophy (Stiglitz, 2012). The mainstream implementation of
instruments such as Eurobonds or group Project bonds which would act as credit rating
pooling devices, in tandem with the European Stability Mechanism could also help provided
finance to the cash strapped governments of the core. All these elements could contribute to
the recovery of European economy and the give Europe the means to rise above the debt
crisis.
Thus it is clear that, empirically, austerity failed as means of reducing the debt-to-GDP ratio
of indebted countries. It was flawed conceptually and had limited empirical justification.
Moreover, the low interest rates and the current liquidity trap means that the expansionary
monetary policy cannot be used to great effect. The only course of action is a German
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financed, investment-based, period of growth. Only once a relative degree economic stability
has been achieved can governments rigorously deleverage.
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Reference list
Alesina, A., 2010.Fiscal adjustments: lessons from recent history. Madrid , s.n., pp. 1 - 54.
BBC News - Business, 2012.Eurozone crisis explained. [Online]
Available at: http://www.bbc.co.uk/news/business-16290598[Accessed 16 September 2012].
BBC News - Business, 2012. Government Borrowing cost (diagram). InEurozone crisis
explained. [Online]
Available at: http://www.bbc.co.uk/news/business-16290598
[Accessed 16 September 2012].
European Central Bank, 2012. The euro area sovereign debt market: lessons from the crisis.
[Online]
Available at: http://www.ecb.int/press/key/date/2012/html/sp120628_1.en.html[Accessed 18 September 2012].
European Central Bank, 2012. Interest rates (diagram). In The euro area sovereign debt
market: lessons from the crisis. [Online]
Available at: http://www.ecb.int/press/key/date/2012/html/sp120628_1.en.html
[Accessed 18 September 2012].
Finfacts , 2008.News: EU Economy. [Online]
Available at: http://www.finfacts.ie/irishfinancenews/article_1014454.shtml
[Accessed 18 September 2012].
Krugman, P., 2000. How complicated does the model have to be?. Oxford Review of
Economic Policy, 16(4), pp. 33-42.
Krugman, P., 2011.IS-LMentary. New York Times: Conscience of a Liberal [blog]. [Online]
Available at: http://krugman.blogs.nytimes.com/2011/10/09/is-lmentary/
[Accessed 11 September 2012].
Lane, P. R., 2012. The European Sovereign debt crisis.Journal of Economic Perspectives,
July, 26(3), pp. 49-68.
Lane, P. R., 20120. The Evolution of Public Debt, 1982-2011 (diagram). InJournal of
Economic Perspectives,July, 26(3), pp. 49-68.
Matheron, J., Mojon, B. & Sahuc, J.-G., 2012. The sovereign debt crisis and monetary policy.
Banque de France - Financial Stability Review, April, pp. 155 - 168.
Shambaugh, J. C., 2012. The Euros Three Crises.Brookings Papers on Economic Activity,
April, 23(1), pp. 1-55.
Shiller, R., 2012.Does austerity promote economic growth? - Project Syndicate. [Online]
Available at: http://www.project-syndicate.org/commentary/does-austerity-promote-
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