June 5 (Bloomberg) -- What we know, or think we know, about fiscal policy five years after the global recession started isn’t all that different from what we knew, or thought we knew, back in 2008. It boils down to two points. One, fiscal stimulus is essential when conventional monetary policy is powerless. Two, fiscal stimulus may be impossible even when it’s essential.
Most economists agree that changes in interest rates are usually a better way to regulate demand than discretionary changes in taxes and public spending. But interest rates can’t fall to less than zero. When that limit is reached -- as it was in this recession -- fiscal policy must carry a bigger load.
In economies with a lot of slack, fiscal multipliers (the change in output that follows from any change in the fiscal balance) are more powerful than usual. This recession, because of its unusual depth, has supplied new evidence to back up this rule, and the U.K.’s attempt to refute the logic with “expansionary austerity” is widely seen as a failure despite some recent tentative signs of recovery.
Moreover, unconventional monetary policy, the other alternative to changes in short-term interest rates, can’t yet be called a success. Only when the Federal Reserve and other central banks end their vast asset-purchase programs will it be possible to render a verdict on quantitative easing as a partial substitute for fiscal stimulus. So far, it looks as though it has helped. Let’s see how the exit goes before we declare it a triumph.
To repeat, fiscal stimulus is essential when conventional monetary policy is powerless. But fiscal stimulus isn’t always an option. Governments can’t do it if investors are unwilling to buy their debt. Greece and other European Union economies discovered this in 2010. Theirs was hardly a new experience.
Europe as a whole had, and still has, unexploited fiscal capacity. It chose not to use it for both good and bad reasons. The good reasons included the desire to force governments to reform their economies in ways they wouldn’t consider unless under pressure. The bad reasons included the idea that the worst-hit countries had brought their troubles on themselves, and shouldn’t look to their EU partners for help.
The right answer is plain, and has been from the start: collective EU fiscal support with conditions. The union has made gestures in that direction, but the scale of the response so far has been pitiful.
What about the view that governments don’t need to worry about fiscal capacity if they borrow in their own currency? A country like Greece can find itself literally unable to service its debts. The U.S. or the U.K., which borrow in their own currencies, could never be forced into that corner. They can simply print the money if need be. Or so it’s argued.
Countries that borrow in their own currency can, in fact, default. Put to one side the periodic threats from the U.S. Congress to repudiate debt as an act of policy. Beyond that, countries may resort to inflation as a way to lighten their debts, and investors are aware of the possibility. A surge in bond yields that would require sudden fiscal contraction is therefore possible even for a country like the U.S.
A country that borrows in foreign currency has to keep debt at levels that cause investors no concern; for the others, that’s merely very desirable. Even for the U.S., heading into the next bad recession with a ratio of debt to gross domestic product of 40 percent would be a lot better than doing so with a debt that is 80 percent of GDP. Fiscal consolidation when the economy is strong is as important as fiscal stimulus when it’s weak: Without the first, you can’t count on the second.
Another finding from the past five years: Building political coalitions around that simple precept -- stimulus when necessary, consolidation when possible -- has proved surprisingly hard. The right has mostly argued for austerity regardless. The left has mostly played down the need for fiscal control later, arguing that as growth resumes the problem will take care of itself.
This is the context that made the findings of Carmen Reinhart and Kenneth Rogoff on debt and growth so controversial. Conservatives seized on their finding that high levels of debt are correlated with lower growth, calling it proof that austerity is needed now, which is a non sequitur. Keynesians seized on an error in one of the authors’ papers and on the fact that correlation isn’t causation to imply that austerity is always dumb, also a non sequitur.
A recent open letter by Reinhart and Rogoff says all that needs to be said on their position and that of their critics. The point I’d stress is that, confounding the positions of the two warring camps, the link between debt and growth almost certainly runs in both directions. The link from low growth to a high debt-to-GDP ratio is clear and immediate: In a recession, dwindling tax revenue and higher automatic outlays increase debt, and slow growth holds back GDP. The link from high debt to low growth is a bit more complicated but still pretty obvious: Higher interest rates crowd out private investment while mounting payments for debt service squeeze public investment and push up tax rates.
It’s silly to ask whether high public debt causes lower growth or vice versa as though it must be one or the other. Almost certainly, both are true. This reinforces the case for fiscal consolidation as the recovery strengthens -- not just to restore fiscal room for maneuver but also to support longer-term growth.
What’s needed is fiscal strength (as conservatives stress) and the willingness to use it boldly when necessary (as Keynesians stress). This simple proposition was true in 2008 and it’s still true. It should be uncontroversial, but it seems to be more than politics can handle.
(Clive Crook is a Bloomberg View columnist.)
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