Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday, 18 August 2014

Balanced-budget fundamentalism

Europeans, and particularly the European elite, find popular attitudes to science among many across the Atlantic both amusing and distressing. In Europe we do not have regular attempts to replace evolution with ‘intelligent design’ on school curriculums. Climate change denial is not mainstream politics in Europe as it is in the US (with the possible exception of the UK). Yet Europe, and particularly its governing elite, seems gripped by a belief that is as unscientific and more immediately dangerous. It is a belief that fiscal policy should be tightened in a liquidity trap.

In the UK economic growth is currently strong, but that cannot disguise the fact that this has been the slowest recovery from a recession for centuries. Austerity may not be the main cause of that, but it certainly played its part. Yet the government that undertook this austerity, instead of trying to distract attention from its mistake, is planning to do it all over again. Either this is a serious intention, or a ruse to help win an election, but either way it suggests events have not dulled its faith in this doctrine.

Europe suffered a second recession thanks to a combination of austerity and poor monetary policy. Yet its monetary policymakers, rather than take serious steps to address the fact that Eurozone GDP is stagnant and inflation is barely positive, choose to largely sit on their hands and instead to continue to extol the virtues of austerity. (Dear ECB. You seem very keen on structural reform. Given your performance, maybe you should try some yourself.) In major economies like France and the Netherlands, the absence of growth leads to deficit targets being missed, and the medieval fiscal rules of the Eurozone imply further austerity is required. As Wolfgang Munchau points out (August 15), German newspapers seem more concerned with the French budget deficit than with the prospect of deflation.

There is now almost universal agreement among economists that tightening fiscal policy tends to significantly reduce output and increase unemployment when interest rates are at their lower bound: the debate is by how much. A few argue that monetary policy could still rescue the situation even though interest rates are at their lower bound, but the chance of the ECB following their advice is zero. 

Paul De Grauwe puts it eloquently. 

“European policymakers are doing everything they can to stop recovery taking off, so they should not be surprised if there is in fact no take-off. It is balanced-budget fundamentalism, and it has become religious.”

They still teach Keynesian economics in Europe, so it is not as if the science is not taught. Nor do I find much difference between the views of junior and middle-ranking macroeconomists working for the ECB or Commission compared to, for example, those working for the IMF, apart from a natural recognition of political realities. Instead I think the problem is much the same as that encountered in the US, but just different in degree.

The mistake academics can often make is to believe that what they regard as received wisdom among themselves will be reflected in the policy debate, when these issues have a strong ideological element or where significant sectional financial interests are involved. In reality there is a policy advice community that lies between the expert and the politician, and while some in this community are genuinely interested in evidence, others are more attuned to a particular ideology, or the interests of money, or what ‘plays well’ with sections of the public. Some in this community might even be economists, but economists who - if they ever had macroeconomic expertise - seem happy to leave it behind.

So why does ‘balanced-budget fundamentalism’ appear to be more dominant in Europe than the US. I do not think you will find the answer in any difference between the macro taught in the two continents. Some might point to the dominance of ordoliberalism in Germany, but this is not so very different to the dominance of neoliberalism within the policy advice community in the US. Perhaps there is something in the greater ability of academics in the US (and one in particular) to bypass the policy advice community through both conventional and more modern forms of media. However I suspect a big factor is just recent experience.

The US never had a debt funding crisis. The ‘bond vigilantes’ never turned up. In the Eurozone they did, and that had a scarring effect on European policymakers that large sections of the policy advice community can play to, and which leaves those who might oppose austerity powerless. That is not meant to excuse the motives of those that foster a belief in balanced budget fundamentalism, but simply to note that it makes it more difficult for science and evidence to get a look in. The difference between fundamentalism that denies the concept of evolution and fundamentalism that denies the principles of macroeconomics is that the latter is doing people immediate harm.  


  1. Great post, Simon. But one might argue that balanced budget fundamentalism is even stronger in some factions of the US, given the push for austerity despite the lack of a debt funding crisis! Thankfully the Fed has proven considerably superior to the ECB.

  2. The balanced budget lunatics are everywhere and it chimes with the public because it's what they have to do. The bond vigillantes can pick off countries who use a foreign currency at will, this can never be an issue where the currency issuer is sovereign unless by political choice. @bill40

  3. I think that the assumption that the European policy elites want economic growth and mistakenly thing they can get it through austerity is wrong.

    European policy elites know perfectly well austerity will not bring growth. But they do not want growth.

    What they want is depression in Southern Europe to enforce internal devaluation and a) ensure Northern European banks get the money they foolishly lent to (some) Southern European countries back and b) ensure the euro continues for a bit longer (possibly until they've somehow insulated themselves from the effects of its inevitable implosion).

    Southern European workers must be kept unemployed and their wages cut as a way to suppress internal demand in Southern Europe, since in the fixed exchange regime that is the euro a recovery in internal demand would necessarily mean an increase in imports from Northern euro countries, aggravating the trade balance deficit and private debt which was the cause of the crisis.

    Mario Monti, the technocrat imposed as Italy's prime minister back in 2011, candidly admitted that the purpose of "structural reforms" was the destruction of internal Italian demand, in as many words (it's in an interview with CNN, available on youtube).

    Of course permanent depression is impossible as the lack of aggregate demand from the South is starting to impact on the North as well, and the rest of the world won't just sit there and soak up Eurozone surpluses forever.

    But as I said the point is keeping the euro going until as many south to north credits as possible are repaid and the current elites have safely run out their terms.

    Local politicians, particularly in the South, will then be left to pick up the rubble. I have no pity for them - it was their choice to behave as extractive colonial elites.

  4. On the topic of stimulus, I read something odd a few days ago, and I thought it would be another BBC watch, but it is a little more than that.

    BBC website 15 August 2014 'South Korea cuts lending rate to boost domestic growth' said:

    "South Korea's central bank has cut its key lending rate to 2.25% from 2.5%. The move, the first cut in 15 months, is designed to boost growth at home, which has been sluggish since the sinking of a ferry carrying hundreds of passengers - many schoolchildren - depressed consumer sentiment."

    Carried below the article is this quote, 'The BoK said in a statement: "In Korea, exports have maintained their buoyancy but the Committee judges that improvements in domestic demand, which had contracted due mainly to the impacts of the Sewol ferry accident, have been insufficient, and that the consumption and investment sentiments of economic agents also continue to show sluggishness."'

    Is it possible for a preventable tragedy to depress 'consumer sentiment', and if not why would a central bank which has been one of the best at fiscal stimulus (Krugman blog July 24, 2010, 'Keynes In Asia' "But the main point here is that Korea and China both engaged in much more aggressive stimulus than any Western nation — and it has worked out well") say as much?

  5. Nice article about something I have wondered for a while.

    You say that when interest rates are at their lower bound "There is now almost universal agreement among economists that tightening fiscal policy tends to significantly reduce output and increase unemployment..."

    ...or perhaps to explain at least a part of the UK's productivity slump?


  6. "The US never had a debt funding crisis. The ‘bond vigilantes’ never turned up."

    Yes and the state level, bonds are clearly priced with default risk. The Fed never buys state debt. And many states have rather strict budget rules.

    1. What your really saying is that investors have concluded the following:

      If a bank goes belly up, the feds will bail it out. If a state goes belly-up, the feds won't. They certainly can point to Detroit as an example.

      Exactly how this is considered good policy is anyone's guess.

  7. Market Fiscalist18 August 2014 at 16:07

    I can see 3 reasons for budget deficits.

    1. To increase AD during a recession
    2. To spread the costs of long term govt projects over a number of years
    3. To avoid taxation in the present being used for spending in the present.

    1 and 2 should never lead to a deficit crisis. 3 may eventually do so. I think the UK economy would have benefited from 1 and 2 over the past few years. But because of a legacy of type 3 this would have increased the risks of a deficit crisis at some point in the future. I think one could make a decent argument that this was a genuine concern and the UK govt acted wisely in implementing limited austerity to avoid this risk.

    1. I do not think you can. Before the recession hit, the debt/GDP ratio was below 40% and the deficit was not far off a sustainable level. More detail here:

    2. Market Fiscalist,

      Your No.2 defies the laws of Physics, never mind economics. That is, it just isn't physically possible for the nation as a whole to pay in 2020 for example for infrastructure investment made in 2014. Steel and concrete produced in 2020 cannot be used to build a bridge in 2014. (I’m assuming the country does not change its net borrowing from abroad.).

      Re your No.3, there is no reason why a big deficit today would cause a “deficit crisis” a few years hence, though it COULD cause a DEBT CRISIS in the sense that debt holders might regard the debt as too high, and thus demand an elevated rate of interest for holding that debt. But there is an easy solution to that: just implement QE, i.e. print money and buy the debt back. And if that is too inflationary, then raise taxes (and or cut public spending). The “problem” there is as good as non-existent. So there is no excuse for austerity now.

    3. Market Fiscalist19 August 2014 at 20:37


      If the govt builds a bridge costing $1000 this year then obviously the physical resources have to come out of current supply.

      But: If the economy is at full employment (no AD shortfall) then if the govt wants to avoid inflation it can either pay for the bridge out of taxation or out of money raised by bond issues. If it wants to spread the cost of the bridge over 10 years it makes sense to use bond issues in year 1, accompanied by higher taxation for 10 years to pay the bond issues down (again assuming no AD shortfalls during the 10 year period).

      on #3: I suppose a govt could always deal with a debt crisis by either inflating it away or raising taxation sufficiently high (or just defaulting). All sound like bad options to me so I draw the conclusion that #3 is best avoided (and some caution is needed for #2 as well).

  8. Good post but I think Professor Wren-Lewis may have skipped one crucial reason why there has been far more austerity in the eurozone than in the US:
    In Europe, decisions are made (mainly) in Germany while the negative effects have been felt mainly by the southern Europeans. It's easy for the German government (and people) to act morally superior and lecture the southerners on the merits of structural reform since the germans feel very little of the pain themselves.

  9. Simon, it's cards on the table time. Where do you stand on "Modern Monetary Theory"? The version that emanates from the University of Missouri at Kansas City. Professed by the likes of L Randall Wray; Stephanie Kelton; Warren Mosler and Bill Mitchell in Australia and Neil Wilson (3spoken) in the UK?

    My big worry is that the current political machine in the UK (all major parties), have no idea how a sovereign fiat currency economy actually works. Particularly evidenced by imposing "austerity", in 2010 on an economy that needed exactly the opposite treatment at that time.

    All the bast Acorn

  10. ''Yet Europe, and particularly its governing elite, seems gripped by a belief that is as unscientific and more immediately dangerous. It is a belief that fiscal policy should be tightened in a liquidity trap.''

    I am not sure this is true. A major reason for surplus countries to refuse monetary stimulus or allowing deficit countries to increase debt is that they are afraid that eventually they will have to foot the bill with transfer payments. As long as taxpayers in surplus countries have no policy influence over for example structural reforms in deficit countries, why would they be willing to accept the risks that go together with more debt? After all, even during the boom years some deficit countries did not significantly lower public debt. How do you solve this political deadlock when a political union is not likely to happen?

    1. This is sometimes said, but it is not logical. No one is suggesting that Germany will have to bail out France, so why the obsession with the French deficit? With German GDP growth zero, why is Germany not talking about fiscal stimulus? Why has the Netherlands introduced one austerity package after another, as unemployment steadily increased?

    2. ''No one is suggesting that Germany will have to bail out France''

      No one thought that banks had to be bailed out, but it did happen

      ''so why the obsession with the French deficit?''

      because they are afraid they need to bail out the French! (and not just the French).
      Or at least that the eurozone will become a transfer union.

      ''With German GDP growth zero, why is Germany not talking about fiscal stimulus? ''

      Germany has low public debt, low unemployment rate, low inflation, export surplus and aging and shrinking population. If you add this up, why would Germany need fiscal stimulus? Maybe they need some higher wages, and this is already happening.
      Looking at UK: Growth numbers are impressive, but inflation has been higher than wage increases for years, what is monetary and fiscal stimulus achieving for average UK worker?
      I would be interested to see the GDP/capita growth rate of Germany and UK.

      ''Why has the Netherlands introduced one austerity package after another, as unemployment steadily increased?''

      Netherlands has small and open economy, and policy makers think that stimulus would boost imports, not local economy.
      And Netherlands had housing bubble, and policy makers believe the solution is not to re-inflate housing bubble, therefore consumer spending will remain low for a while.

      And Netherlands and Germany already have high taxed mixed economy, how large do you want government spending as part of economy to be?

    3. "No one thought that banks had to be bailed out, but it did happen"

      This is the end choice - do some sort of fiscal union - or indeed Germany will eventually have to bail out the banks - The German banks who lent the money.


    4. 1) Why is there a presumption that Germany has to bail out Eurozone countries that default. That is what the IMF is for. But perhaps an IMF bail out would be less kind to creditors e.g. German banks?
      2) Germany is going to steadily lose its export surplus as Eurozone countries regain competitiveness, so it needs to start replacing external demand with domestic demand. There is no fiscal stimulus in the UK.
      3) Stimulus can be directed at non-traded goods. It also has nothing to do with the long run size of the state.

    5. ''Why is there a presumption that Germany has to bail out Eurozone countries that default. That is what the IMF is for.''

      The Lisbon treaty ''no bailout'' clause is a dead letter, just look at programmes like the ESM. No eurozone country is likely to default, I don't see a role for the IMF in this.
      The subtle political game that probably will be played in the coming years or decades is between deficit countries who want a transfer union and surplus countries who don't.
      I think you need to evaluate any eurozone political decision with taking this into account, instead of just assuming irrational budget fundamentalism.

    6. Why is there a presumption that Germany has to bail out Eurozone countries that default. That is what the IMF is for. But perhaps an IMF bail out would be less kind to creditors e.g. German banks?

      Simon I think you need to study a financial crisis case study. The Asian Financial Crisis is a good one. The response of countries that were forced to pick the IMF's SAPs said "never again". For this reason they have followed a policy of
      accumulating foreign exchange reserves, or at least making sure they do not slip below a minimum. It is about sovereignty. It is not about liquidity trap arguments.

      Now actually Greeks are willing to surrender some sovereignty if there is a fiscal union - I will get to that in a minute.

      The lessons of the Asian Financial Crisis were anything but a vindication of classical, let alone Neo Classical or New Classical Theory. Reliance on foreign capital is bad (despite arguments about comparative advantage etc.). Greece and Italy want to get out of a situation long term where they are dependent on Germany, economically, which means politically, even if it means not stimulating the economy during a recession. There is not a sufficient industrial base in these countries. An AD stimulus would immediately lead to an increase in imports. The costs of imported inputs along outweigh the price of low value added exports. They require fundamental structural adjustment. Germany realises this which is why they know that large scale disbursement without structural reforms will not solve the underlying problem, but probably worsen it.

      Interestingly Greeks and Italians do not want a return to the pre-Euro Drachma or Lira and the old habit of devaluations. The answer is fiscal union within the EU. This means sacrificing sovereignty, but Greeks will have more of a say in the political process. But understandably before this happens Germany wants safeguards to ensure its hard earned money is not squandered.

    7. I think one of the dangers of neo-liberal theory (approximately neo-classical theory in economics) is that it assumes a one-size-fits all model. Usually what happens the debate in the most powerful country - the US - dominates everywhere else.

      LIquidity trap arguments are arguably relevant to the US, Japan and perhaps the UK. But really it is not the fundamental problem in the Eurozone, especially the Eurozone periphery.

    8. Germany is going to steadily lose its export surplus as Eurozone countries regain competitiveness

      Against Japan and increasingly China? As far as I know these are the major competitors to German exports.

  11. Speaking of things both amusing and distressing: :D

  12. While it is worth trying to explain why balanced budget fundamentalism is nonsense I think we all know that the debate is theatre and the audience that matters, the one in Germany, is uninterested - they prefer opera.

    Germany currently enjoys an effective stranglehold on monetary policy in the EU and fiscal policy in the periphery and is forcing the current policy course because it suits the country politically, economically and financially, not because there is a belief that the policy is likely to restore economic growth or employment outside Germany. The policy has also left the social democratic tradition severely weakened which again suits German government doctrine.

    From a financial point of view (both public and private) the primary focus of Germany's EU policy is to allocate as much as the cost for the European component of the financial crisis on other countries and it has been fairly unapologetic about this, first banks were sacred, now taxpayers are - whatever minimizes the threat to German wealth is policy. The emphasis on balanced budgets and low interest rates is also about preserving national wealth by enforcing debt repayments on the GIPSIs (debts which should largely have been written off and/or monetized) though control of EMU.

    Further even if you could persuade Germany that the overall contraction of the European economy caused by austerity is going to hurt its economy you would have to show that the losses from reduced GDP growth were more than the benefit from low inflation given their creditor status.

    Finally if you had the numbers to show that economics is not a zero sum game you would be confronted by the problem of entrenched neoliberalism in Germany and the European Commission. Neoliberalism is a romantic tradition and it is not amenable to a scientific critique for that reason. As a utilitarian you might believe that the ends justifies the means, ordoliberals are instead convinced that the means justifies the ends.

    I saw Professor Sinn give a public lecture in Dublin. When asked what his position on fiscal stimulus was the emotions the question aroused in him were so intense that he developed a stutter and could only splutter that it was simply the wrong thing to do. The man is literally beyond reason and he and the IFO represent mainstream economic thought in Germany.

    For all these reasons talking about the wrong headedness of balanced budget fundamentalism is now almost useless. The arguments need to move to whether a European Union that is permanently bent to Germany's needs can be tolerated and if not what, if anything, can be done to change it.

    The economic debate is long settled, this is politics.

    Micheal, Ireland

  13. "When asked what his position on fiscal stimulus was the emotions the question aroused in him were so intense that he developed a stutter and could only splutter that it was simply the wrong thing to do. The man is literally beyond reason and he and the IFO represent mainstream economic thought in Germany."

    I think these criticisms are unfair. There is a lot of hypocrisy coming from Anglo-American commentators and "experts" who think that a command of "standard" economic theory gives them special insights into the problems of the Euro-zone periphery and what the German people and establishment think. Remember this, whether they understand "standard economic theory" or not the Germans know how to run an economy. The proof is in the pudding. They should be teaching us. Secondly, it is wrong to think that they are pursuing a policy which they believe is beneficial to Germany at the cost to the periphery. The German people I meet are genuinely concerned about the Eurozone. They want to find a solution. They want the EU and the Euro to survive. There is stronger support there for such things than the UK, for example. They gave up a super-currency, the DM for the Euro. And they are willing, unlike Whitehall, to put their money where their mouths are. But first it must be done in a way which solves the underlying problems.

    1. Well of course they want the Euro to survive. Being part of the currency union gives them the artificially low exchange rate that suits their export model perfectly. Just imagine how "super" the DM would be now, and the effect that would have on Germany's exports.

    2. Wrong. A strong currency is very much part of the German School of Economics. It goes back to Friedrich List.

  14. Dear Prof. Wren-Lewis,
    here's an article, in German, unfortunately, describing how German Finance Minister Schaeuble prefers to employ jurists over economists in his department:
    Now, people with a legal education probably prefer rule-based policies which means that the power of Keynesian economics, with its discretionary measures, is very much diminished now. The piece goes on to explain that Mr. Schaeuble dislikes how economists frequently can't make up their minds about possible policy effects. I guess it's because there are internal conflicts between Keynesians, Ordoliberals and Neo-classicals. Also, the standing of economics has sunk in the wake of the Financial Crisis, so Mr. Schaeuble has come to disregard their opinions.
    If I had to guess I'd say that the professionally educated economists there are Keynesians or Neo-Classicals, while the jurists represent Ordoliberalism. The current policy preferences of a balanced budget, extremely low inflation, and a fixed debt/GDP ratio are very much rule-based policies that completely rule out discretionary measures in the times when they're needed the most.

    1. Thank you very much for this interesting input.

    2. Interesting insight, Thankyou.

  15. "as unscientific"

    Hardly. Economics is so far from being a science that such a comparison is just stupid. Really, just stupid.

    French government spending as the percentage of the economy is the highest in the eurozone and one of the highest in the world. So the French government should spend more? How does that make sense, except to a Keynesian who has one hammer and sees every problem as the same nail? Stupid, just stupid.

  16. "Dear ECB. You seem very keen on structural reform. Given your performance, maybe you should try some yourself."
    This is exactly what I support, changing the Maastricht treaty to reform the ECB. Unfortunately such reform seems unlikely, despite its clear necessity. The few times I've seen this brought up it seems to be shot down by politicians and other policy makers with more or less incoherent arguments. All I get is that it's a taboo subject.

  17. It seems a couple of things are left overlooked:

    1) The Eurozone has a common central bank, but very little, if any, power over the member states. This makes it very hard to make and enforce agreements on spending and lending.

    2) The southern member states have a history of mismanagement and racking up debts, even in the good times, the northern member states don't want to end up paying for that, but that also means they have to stick to tight budgets themselves to avoid appearing hypocritical.

    3) The member states are allowed to, and do, run deficits of 3% of GDP over extended periods and even higher deficits for shorter periods.

    4) It's naive to see the current crisis as simply a lack-of-trust-crisis ready for the Keynesian approach (in other words, there being the potential for much higher economic output if only someone would start spending again). We may very well be in a perfect storm that not only contains a crisis of the financial system but also an aging (retiring) population and a marked increase in competition from countries where labor is much cheaper. Stimulus money won't make old people young again and won't stop countries like China, Brazil and India from reducing their productivity gaps with the rich countries, gaining an increasing share of the total purchasing power available to buy ever scarcer natural resources.


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