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Current Issues in Economics Policy response Austerity vs. stimulus 1.

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1 Current Issues in Economics Policy response Austerity vs. stimulus 1

2 Policy response Austerity vs. stimulus Six years after the global crisis erupted, the world’s mature economies – especially the Eurozone – find themselves with shockingly fragile economies. Have the austerity programs adopted by countries since 2011 been cutting too much and too soon? Has austerity triggered a self-defeating ‘doom loop’ whereby budget cuts and tax rises widen deficits by throwing economies into tailspins? Is spending more by increasing public debt a solution? 2

3 Policy response Austerity vs. stimulus In US crisis originated from private financial sector but with monetary (low interest rates) and mortgage guarantees encouragement from the state. In Europe, causality mostly flowing from public to private. – In a fiscal crisis associated with large fluctuation in sovereign risk, financial intermediaries that suffer losses on their holdings of government bonds may slow down lending. – Financial and non-financial firms face higher risk of loss of outputs and profits due to tax hikes, increase in tariffs, disruptive strikes, and social unrest, not to mention lower domestic demand. 3

4 Policy response Austerity vs. stimulus Hope of soft landing The ability to finance macroeconomic imbalances through easy foreign borrowing allowed US and countries of Euro zone to postpone tough policy choices. Investors’ appetite for public debt that turned out to be toxic provided one ready source of external funding of the deficit. At the same time, countries with current account surpluses (first of all China) faced minimal pressures to adjust. 4

5 Policy response Austerity vs. stimulus The world is seized by a debate between fiscal austerity and fiscal stimulus. Opponents of austerity worry about contractionary effects on the economy. Opponents of stimulus worry about indebtedness and moral hazard A procyclical fiscal policy piles on the spending and tax cuts on top of booms, but reduces spending and raises taxes in response to downturns. Budgetary profligacy during expansion; austerity in recessions. Procyclical fiscal policy is destabilising, because it worsens the dangers of overheating, inflation, and asset bubbles during the booms and exacerbates the losses in output and employment during the recessions. In other words, a procyclical fiscal policy magnifies the severity of the business cycle. 5

6 Policy response Austerity vs. stimulus Austerity describes policies used by governments to reduce budget deficits during adverse economic conditions. These policies may include spending cuts, tax increases, or a mixture of the two. Austerity policies to demonstrate governments' fiscal discipline to their creditor and credit rating agencies by bringing revenues closer to expenditures; they may also be politically or ideologically driven 6

7 Policy response Austerity vs. stimulus Stimulus refers to attempts to use monetary or fiscal policyto stimulate the economy. Fiscal stimulus refers to increasing government consumption or transfers or lowering taxes. Effectively this means increasing the rate of growth of public debt except that particularly Keynesians often assume that the stimulus will cause sufficient economic growth to fills that gap partially or completely. Monetary stimulus refers to lowering interest rates, quantitative easing, or other ways of increasing the amount of money or credit. 7

8 Policy response Austerity vs. stimulus Quantitative easing (QE) is an unconventional monetary policy used by a central bank to stimulate an economy when standard monetary policy has become ineffective. A central bank implements quantitative easing by buying specified amounts of financial assets from commercial banks and other private institutions, thus raising the prices of those financial assets and lowering their yield, while simultaneously increasing the monetary base. This differs from the more usual policy of buying or selling short-term government bonds in order to keep interbank interest rates at a specified target value. 8

9 Policy response Austerity vs. stimulus 9

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11 Policy response Austerity vs. stimulus According to IMF, the quantitative easing policies undertaken by the central banks of the major developed countries since the beginning of the late-2000s financial crisis have contributed to the reduction in systemic risks The QE policies also contributed to the improvements in market confidence and the bottoming-out of the recession in the second half of 2009. 11

12 Policy response Austerity vs. stimulus Today policymakers, whether they actually recognize it or not, are caught in a debate between the thinking of two great economists: Keynes and Friedrich Hayek. The practical implications of this intellectual debate shape action in terms of choosing either more austerity or stimulus. Keynes - unemployment and idle resources caused by a lack of effective demand Hayek, they stem from a previous, unsustainable episode of easy money and artificially low interest rates 12

13 Policy response Austerity vs. stimulus What economists could know? In 2003, Robert Lucas of the University of Chicago, in his presidential address to the American Economic Association, declared that the “central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.” The Queen of England asks economists – “Why did nobody notice?” 13

14 Policy response Austerity vs. stimulus Disappointing institutional response Official discussion of the risks posed by large global imbalances intensified in the fall of 2003 as G7 officials pressured Japan and (verbally) China to reduce their intervention purchases of dollars. At the G7 and IMF meeting in Dubai in 2003, the United States also pledged to take steps to promote national saving, while Europe committed to raise productivity. Later, in February 2004, the G7 finance ministers and central bank governors asserted clearly that, along with structural policies to enhance growth, “sound fiscal policies over the medium-term are key to addressing global current account imbalances.” 14

15 Policy response Austerity vs. stimulus In 2009 many countries rolled out big packages of tax cuts and extra spending in the hope of buoying growth. This stimulus amounted to 2% of GDP on average among the members of the G20 club of big economies 15

16 Policy response Austerity vs. stimulus Multiplier effect Sceptics - it would be low, and that neither stimulus nor austerity would have much effect on output or jobs. Stimulus simply absorbs resources that would otherwise have been used by private firms. Firms and households would probably save their share of the proceeds, rather than bolster the economy by spending them, since they would assume that it was temporary. Optimists -ith unemployment high and private demand for loans low, there was little risk that the government would “crowd out” private activity. Indeed, with indebted households forced by falling asset prices to pay off loans quickly, a boost to incomes from a fiscal stimulus would speed the financial adjustment, and thus generate a faster recovery. 16

17 Policy response Austerity vs. stimulus Supporters of stimulus looked to the ideas of Keynes. Depression occurs when too many people want to save and too few to invest, then resources (including workers) fall idle. Firms and families might save too much because of financial uncertainty or because they are rushing to “deleverage”—to reduce the ratio of their debts to their assets. When there is slack in the economy, fiscal stimulus can be particularly powerful thanks to a “multiplier” effect. A dollar spent building a railway, for example, might go to the wages of a construction worker. He then spends the extra income on groceries, enriching a shopkeeper, who in turn goes shopping himself and so on In normal times central banks would try to spur growth by adjusting interest rates to discourage saving and encourage borrowing. Yet by early 2009 most central banks had reduced their main interest rates almost to zero, without the desired result. Over indebtedness, have been preventing people from borrowing as much as they would like, whatever the interest rate. Governments needed to make up for firms and families, by borrowing and spending more (or taxing less) to put excess savings to work. 17

18 Policy response Austerity vs. stimulus In many cases, austerity measures have been associated by critics with a decline in living standards and have led to popular protest. The financial crisis—particularly the austerity package put forth by the EU and the IMF—was met with great anger by the Greek public, leading to riots and social unrest 18

19 Policy response Austerity vs. stimulus IMF U-turn Most recently, however, capitalism has been characterized by “excess”—in risk-taking, leverage, opacity, complexity, and compensation. It led to massive destruction of value. It has also been associated with high unemployment, rising social tensions, and growing political disillusion – all of this happening in the wake of the Great Recession. Christine Lagarde Managing Director, International Monetary Fund, 2014 19

20 Policy response Austerity vs. stimulus Supporters of austerity - fiscal stimulus is needed most when governments already have extra costs to bear. From 2007 to 2010 rich countries saw the ratio of their gross sovereign debt to GDP spike from 74% to 101% on average. British public debt jumped from just 44% of GDP to 79%, while America’s leapt from 66% of GDP to 98%. Greece’s soared by 40 percentage points, to 148% of GDP 20

21 Policy response Austerity vs. stimulus Germany the main supporter of austerity and enemy of stimulus 21

22 Policy response Austerity vs. stimulus Is austerity good or bad? It is a wrong question. When an economy is in a boom, the government should run a surplus; other times, when in recession, it should run a deficit. Many politicians in the developed countries live by procyclicality. They argue against fiscal discipline when the economy is strong, only to become deficit hawks when the economy is weak. Historically, developing countries used to be the ones where dysfunctional political systems produced procyclical fiscal policies during 1960-99. But things have changed. Remarkably, during the decade 2000-10, about a third of emerging market governments took advantage of the boom years 2003-7 to strengthen their budget positions, saving up for a rainy day. They were thus in a good position to ease up when the global recession hit them in 2008-9. 22

23 Policy response Austerity vs. stimulus Today, global economy faces both lack of demand as consumers continue to reduce debt as well as structural barriers on the supply side due to lack of investment in human and physical capital, which has limited economic potential There has been a misallocation of capital due to a period of artificially low interest rates. 23

24 Policy response Austerity vs. stimulus Need for balanced approach IMF managing director in August 2011, "For the advanced economies, there is an unmistakable need to restore fiscal sustainability through credible consolidation plans. At the same time we know that slamming on the brakes too quickly will hurt the recovery and worsen job prospects. So fiscal adjustment must resolve the conundrum of being neither too fast nor too slow. Shaping a fiscal consolidation is all about timing. What is needed is a dual focus on medium-term consolidation and short-term support for growth. That may sound contradictory, but the two are mutually reinforcing. Decisions on future consolidation, tackling the issues that will bring sustained fiscal improvement, create space in the near term for policies that support growth. 24

25 Policy response Austerity vs. stimulus Stimulus temptation As growth returned in 2010 some leaders argued that it was time to trim public spending. Others worried that the recovery was too fragile to permit any hint of austerity. There was no question that “fiscal consolidation” would eventually be necessary, but much dispute about when it should start. 25

26 Policy response Austerity vs. stimulus Deeper roots The debate is not about the need for fiscal discipline. In advanced countries, with an aging population and rising healthcare costs, the large expansion of debt due to the crisis is an unwelcome addition to the fiscal burden, and requires a convincing policy response. Rather, the debate is about the extent to which spending cuts and tax hikes in the short run are desirable and effective in containing the prospect of sovereign risk crises. 26

27 Policy response Austerity vs. stimulus Strategies that involve short-term stimulus with longer-term austerity are not mutually exclusive. Steps can be taken in the present that will reduce future spending, such as on pensions by reducing cost of living adjustments or raising the retirement age for younger members of the population, while at the same time creating short-term spending or tax cut programs to stimulate the economy to create jobs. 27

28 Policy response Austerity vs. stimulus Lesson from history (that there are no lessons) For the first time since the 1930s, the world is suffering from a persistent lack of adequate demand; people just aren’t spending enough to make use of the productive capacity we have. This was supposed to be a solved problem, one that may have bedeviled our grandfathers but wasn’t going to come back. Economists thought we had macroeconomic policymaking under control. Demand management was assigned to technocrats at independent central banks while fiscal policy focused on long-run issues. In the face of large, sustained shocks, however, it turns out that this system breaks down. On one side, central banks are constrained both by the zero lower bound—the fact that interest rates can’t go negative—and by concerns over the size of their balance sheets. On the other, fiscal policy, far from helping, quickly began making things worse. Krugman 28


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