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 here. So 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.