Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 17 March 2012

Austerity and not wasting a crisis

                In the austerity versus stimulus debate, I argue from a macroeconomic point of view that this is a false choice if we are talking about economies where markets are eager to buy government debt i.e. pretty well everywhere apart from the Eurozone. In the short term we need stimulus, whereas fiscal discipline is a long term problem. We need to raise taxes and cut spending when times are good, not when times are bad. The Eurozone 2000-2007 is a clear example of when this should have happened.
                The response is often to concede the macroeconomic logic, but say that promises of austerity tomorrow cannot be trusted. It is easy to promise, but when tomorrow comes governments will break that promise. This resonates, but it is less clear what the underlying logic is. We can all agree that governments are subject to deficit bias. There are a number of reasons for this: the common pool problem, over optimistic forecasts, political impatience stemming from elections etc. (See Calmfors and Wren-Lewis, 2011, for a more complete account.) However bias stemming from these causes is fairly constant: it does not disappear when deficits are high and only materialize in good times.
                I sometimes put it this way. Suppose the government did go for fiscal stimulus today, and this helped lead to a macroeconomic recovery. Once the recovery was complete, the underlying fiscal position (i.e. the structural or cyclically adjusted deficit) would be a little worse than today, because the stimulus would have added to debt. So if a politician is prepared to undertake austerity today, they will be even more willing to undertake it tomorrow. Of course following a recovery the actual (rather than structural) deficit may be smaller, but is our macroeconomic discourse that naive?
                In economics we are of course used to the optimal policy changing solely as the result of the passage of time (time inconsistency). A central bank may promise to keep interest rates high for some time to reduce inflation today, but come tomorrow when the policy has done its job it becomes optimal to reduce interest rates. However when it comes to fiscal policy and deficit bias, the role of time inconsistency seems less central. The problem is not that we have a benevolent policy maker that is subject to a time inconsistency temptation; it is that we do not have a benevolent policy maker.
                Having said this, I think many feel that, when governments are prepared to act ‘out of character’ and impose restraints on themselves, this chance should be grabbed before it disappears. It is often possible, when looking at countries where government debt is not a major problem, to trace this back to changes made following a fiscal crisis. Lars Calmfors has a nice account of the Swedish case hereSo can we rationalise this idea? Perhaps a crisis, and therefore the chance to act, is not governed by the level of debt (funding problems aside), but by its rate of change. So governments became prepared to impose austerity when debt started rising rapidly following the recession, but if nothing was done and debt remained high, the political imperative would gradually disappear. Higher debt would become the new normal.
                However I still have problems with this line of reasoning. As Lars emphasises, Sweden was successful because it instituted a comprehensive set of reforms following the crisis, including a fiscal target to be achieved over the course of the cycle. It was also successful because a large nominal depreciation boosted output growth, more than offsetting the deflationary impact of fiscal consolidation. The world as a whole cannot use this trick, so an important condition for successful global fiscal consolidation is missing. However countries could establish rules today that were designed to only begin operating when the economy has recovered. Use the current crisis to get the rules established, but recognise that their implementation needs to be delayed because of the recession.
                It is often said that instituting rules that only operate once the recovery is complete will ‘not be credible’. Here is the time inconsistency analogy again, and (funding crisis aside) it seems equally inappropriate. We just need to ask: credible to whom? Is a government that commits to future austerity that begins tomorrow, any more likely to renege in the future than that same government that commits to long term austerity and starts it today? We could argue the opposite: an austerity plan in conjunction with a recession is more likely to come unstuck.
                I think a mistake we can make here is to imagine we are trying to discover the preferences of two different governments. In that case, a government that just promises future austerity tells us very little, because it could just be cheap talk. If a government undertakes austerity now, we know more through its actions. However that is not what the current debate is about. In practice we have governments that are prepared to undertake austerity now. They have demonstrated that they take the debt problem seriously. Are these preferences going to change if we delay austerity until after the recovery?
                So let us, by all means, not waste a fiscal crisis. Use it to set out a combination of rules and institutional changes that avoid deficit bias in the future. However I do not see why it is politically impossible to delay the implementation of those rules until after the recession is over. But maybe I’m just displaying my ignorance of political science.


  1. Totally Agree. Greece is lost (, let's hope we'll avoid the same happening in the future

  2. Political viability is a huge issue here. I've been very into politics since I was a kid (in the US), so I've followed it closely for a long time. I feel I can comment on it in America, but I don't know much about the situation in Europe.

    In the US, the Republican Party has gotten very extreme over the last generation, as you've seen Paul Krugman write about regularly. One issue dominates all others, by far, keeping taxes on the rich as low as possible – All other priorities pale in comparison. Anything that raises taxes on the wealthy, now or in the future, will face a brick wall of Republican opposition.

    Unfortunately, in our system, recently, the filibuster went from something that was very rarely used, to a common occurrence. This means that often you need 60% in the Senate. And it's very rare that you'll have 40% Republicans or less. There is, however, something called reconciliation, which is often applicable, where only 50% is needed (with the Vice President breaking a tie). In addition, there is strong and growing pressure to reform or end the filibuster (thank goodness, see:, so that's a factor.

    Bottom line, it seems to me that something like this would be difficult in the US, but with a strong election for the Democratic Party, possible, maybe if a President really believed in it strongly and pushed it. It'd be tough though; the Republicans hate anything that sounds like government involvement in the economy (unless it's focused on helping a key constituency or corny), and if it involves rasing taxes on the rich, 100% opposition. However, over the next generation, demographic shifts strongly favor the Democrats (see:

    Another idea is increasing spending, but on positive social NPV investments (and there's tons, education, infrastructure, basic scientific research, alternative energy,...) This would increase spending during the recession AND decrease the expected long-term deficits at the same time. It could very justifiably be sold as a recession fighter and a deficit fighter at the same time. This idea is gaining traction in the US, and was an important part of Obama's 2009 stimulus bill. Certainly, the Chinese appear to believe strongly in positive social NPV investment. Do you think it could sell well politically in Europe?

  3. Prof. Wren-Lewis,

    Re your “Lessons from failure…” paper, I fully agree with your advocacy of fiscal committees that have the same real powers that central banks have over monetary matters. I’ve advocated that on my blog for some time.

    Re the section of your paper headed “The lack of research on optimal debt.”, I suggest a fair amount of thought has actually gone into this. Milton Friedman advocated a zero debt regime. See p.250 under the heading “Operation of the proposal” here:

    Warren Mosler advocates the same. See 2nd last paragraph here:

    Plus I had a go at demolishing some of the popular arguments for government debt here:

  4. "Suppose the government did go for fiscal stimulus today, and this helped lead to a macroeconomic recovery. Once the recovery was complete, the underlying fiscal position (i.e. the structural or cyclically adjusted deficit) would be a little worse than today, because the stimulus would have added to debt"

    genauer says:
    The German experience and I would even say in general is that stimulus does not work beyond, lets say 1 or 2 years, but that expectations stay for many years, and the Fiscal position is dramatically worse after that. For the short term you have stabilizers like unemployment insurance and "arbeitszeitkonten" & "kurzarbeit". Instead of copying such good things, many folks in other countries want to destroy it. Just like Boris and the goat.

    After the year 2000 politicians and economists have AGAIN shown a total failure of character in most countries, not saving in good times. Now they have to save in hard times, nothing new under the sun.

    Most Euro governments have again, just as in the 70ties and 80ties, shown to be not able to live by rough general rules like the Maastricht treaty, so now they get the detailed "fiscal compact" rules. People who can not behave like adults, are not trusted as adults, and are put under adult supervision (IMF, Troika).

    What, from my perspective, most economists forget, is that these governments have been found wanting by investors, especially their own people, and after considerable patience. Why does somebody sell a portugues bond at 70 % value, if he would believe them paying on time and in full ? And this is the logical consequence of the politicians / peoples persistent bad behaviour. This does not come like lightning out of a blue sky.

    For good reason, nobody with money believes any promises of "austerity later" any more, based on experience.

  5. Who is calling for austerity? Creditors. Why? Because they fear - irrationally - that fiscal stimulus will lead to inflation.

    This fear is unfounded in a balance sheet recession, because there is a lack of borrowing in the private sector that could be crowded out by public borrowing. Worse, austerity actually deepens recessions and can end up increasing the government debt:GDP ratio - the very opposite of its supposed intended goal.

    News flash for creditors: current UK inflation is cost-push inflation driven by commodities prices (i.e.: Asian demand). It is not demand-pull inflation from excessive borrowing by the public or private sector.

    Japan has a government debt of 200% of GDP and has no problems with servicing this debt or with inflation.

    The whole of UK government policy is driven by the thoughtless gut instincts of creditors.

    It's important to note that the austerity-stimulus debate is not a left-right issue. Conservatives could cut spending massively, as they have done, but also cut taxes on the middle class even more to ensure a government deficit large enough to maintain GDP growth.

    1. Indeed. And this is why our host's concession to the austerity advocates ("we can all agree that governments are subject to deficit bias") is so ill-advised.

      In the context of the present recession/depression, the bias of most governments has been overwhelmingly in favor of austerity--a systematic bias against running sufficiently-large planned deficits to bring their stricken economies rapidly back to full employment.

      This is painfully obvious to any clear-eyed observer of the political scene. To advocate a substantial increase in deficit spending, and the attendant rapid return to full employment, is to place oneself beyond the pale of respectable opinion.

      This is why, e.g., Labor is finding it so difficult to capitalize politically on the massive failure of the Conservative/Lib-Dem economic policy: The Government has the conventional wisdom on its side, and the Opposition dare not make a frontal assault against this conventional wisdom, so deeply has it become entrenched in the public mind, over the course of the neoliberal era.

      So, no: the so-called 'deficit bias' of governments is emphatically not, I'm afraid, something we can all agree about. It is, rather, a key element of this same conventional wisdom and, as such, part of the ideological mechanism preventing a rational solution to the present crisis.

  6. "However I do not see why it is politically impossible to delay the implementation of those rules until after the recession is over. But maybe I’m just displaying my ignorance of political science."

    Indeed you are. Although political science is a misnomer. When people take on cheap debt, it is a pleasant thing that can't go on. Quitting it is hard, and while you can try to take it down gently, you have to start doing quitting today. It is not credible to push all the pain to tomorrow.

    Also, you seem to assume an elite-led society. But in democracy the people have the last say, and leaders are not treated like medical doctors.

    Medical doctors rely on science, and macroeconomics is not. Perhaps there is where the problem is: you are a part of a crank society.

  7. I suspect that in GB the answer is that current Economic policies are aimed at achieving the political end of the erosion of the welfare state and the cuts implicit in this are more 'acceptable' if it is believed 'there is no other way'. Unfortunately Economics is far from being regarded as an exact science/Art therefore politicians pick and mix the theories that resonate politically with them. There is little general understanding of macroeconomics, most public 'debate' is in sound bites and homely anology so there is little external pressure for justification and and explanation as it's 'common sense' to immediately cut and do without when in debt .

  8. Anonymous said at Mar 18, 2012 05:25 AM

    "Unfortunately Economics is far from being regarded as an exact science/Art [...]"

    Macroeconomics is definitely not an exact science. You can't apply scientific method to it.


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