Austerity Is Not Working: How to Restore Economic Growth

In Europe, a major shift is taking place in attitudes toward austerity policies.  This shift is not yet evident in Germany, but it is very apparent in a number of Eurozone periphery countries, in the Netherlands, and in the public debates underway on both sides of the Atlantic on the need to provide stimulus to economies entering recession or falling deeper into depression. The purpose of this note is to outline how sovereign governments can re-establish positive economic growth without increasing public debt further.

The theoretical case against sharp austerity has been established by various commentators.  Data is accumulating daily showing that countries engaged in deep austerity are clearly not reaching debt reduction objectives, but are moving inexorably toward deep depression.  The key points are:

  • Austerity directly reduces incomes and jobs as a first round effect.  This then works to lower revenue, increase public expenditure, increase the deficit and raise public debt; in turn, interest rates move higher. In an environment of high private debt and banking sector deleveraging, confidence plummets. But by then, the high fiscal multipliers evident during the downturn come into play, and output falls further (see Pontus Rendahl, “Fiscal Policy in an Unemployment Crisis”, University of Cambridge Working Paper, February 2012).  As economic activity falls, the burden of debt increases, and credit ratings are downgraded further.  The risk is a self-perpetuating downward spiral, particularly if a group of neighbouring countries all adopt austerity policies at the same time.
  • Austerity policies are not necessary to bring about an internal deflation of unit wage costs and prices.  That could be achieved more directly, and with less drawn-out disruption, by a prices and incomes policy (aimed at lowering domestic wages and prices in tandem, or otherwise as appropriate taking account of profitability levels), or by devaluation (precluded for the Eurozone periphery countries).
  • Austerity policies are predicated on a naïve belief that budget deficits are bad.  This represents a case of misplaced fundamentalism.  Budget deficits are, in fact, desirable, and necessary, to stop private sector demand and output falling, and to create economic growth.  It is not the budget deficit itself that creates a problem; rather, it is the adoption of the bond sale method to finance the budget deficit that creates, and perpetuates, the debt problem.

The need for a broad framework for policy analysis and decision

Macroeconomists are moving toward a consensus, variably expressed, that there is a need to provide stimulus to restore economic growth without raising debt further. The difficulties are manifold as policy options are few.  The IMF calls for a combination of appropriate fiscal consolidation and structural reforms. Much would depend, in the medium-term context, on the time frame for such fiscal consolidation, and whether there are enough structural reforms that can increase competitiveness and demand. Such policies exist, most likely in respect of wage/labour markets and good markets.  Care would need to be taken, however,  not to deepen recessions in the short-term.

However, in the modern era, monetary policies ― and greater synergistic coordination between monetary and fiscal policy ― seem to be off limits, as monetary policies are determined in a separate silo.  Apart from meeting strict inflation targets, monetary policy is currently directed at printing new money to either lower longer-term interest rates, even though short-term rates are at zero bound (USA, Japan), or to defensively, and more or less continuously, mop up excessive public debt as part of a never-ending merry-go-round (Eurozone). To the extent that monetary policy is involved in ‘bail-out’ strategies they seek to fight debt problems by issuing even more debt.  These applications of monetary policy do not address the sources of the problems (deficient demand and ongoing fiscal deficit financing), waste opportunities, and are limiting the prospects for economic recovery.

As the number of policy options is constrained, governments and ministries of finance need to consider the full range of economic policy possibilities, including incomes policies, exchange rate policies, structural policies and alternative means to finance ongoing budget deficits.  The roles, status and objectives of central banks may also require reconsideration, as the age of high inflation has been replaced by the age of high debt.

Financing budget deficits

Returning to the central theme, there are essentially three methods that can be used to finance ongoing budget deficits.

Method a):      conventional bond financing;

Method b):      raising taxes;

Method c):      new money creation.

In respect of these options, Method a) involves the issuance of new government bonds and leads directly to an increase in public debt.  Where the new government bonds are issued to the public, potential purchasing power is withdrawn from the private economy as the bonds are purchased.

Method b) may have greater utility than Method a), as public debt does not increase, but the raising of new taxes also withdraws potential purchasing power from the private economy.

Method c) provides fiscal stimulus, does not increase public debt (in a world where it is assumed that new money will be created, in any event, to counter depression) and does not withdraw purchasing power from the private economy.  Method c) addresses the debt problem directly, at its source.  If Method c) is successful in raising aggregate demand, then the benefits of needed structural/deregulation reforms aimed at raising productivity, lowering costs and improving competitiveness will be magnified.

Implementation of Method c)

Financing budget deficits without raising levels of public debt cannot be achieved by simply requiring a central bank to print money.  To ensure the integrity of its balance sheet, the central bank needs to receive assets in the form of new bonds issued by the government to facilitate the transfer of the new money to the government.  As government bonds held by the central bank are counted as part of public debt, an alternative mechanism is needed to create the new money to finance the budget deficit.

The Ministry of Finance could create new currency and use this new money to finance the budget deficit.  This mechanism would result in two currencies circulating simultaneously.

An alternative strategy would have the central bank and the Ministry of Finance both printing new money simultaneously, and then exchanging it.  In that way, in the case of periphery countries, Euro issued by the ECB would be used to finance the deficit.  There would be no need for two currencies to circulate in the economy.

The current ‘debt’ and ‘growth’ problems are embedded and profound.  As there are few viable solutions, governments and advisers need to carefully explore all options. (The above solution is set out in detail in Wood. R., ‘Delivering Economic Stimulus, Addressing Rising Public Debt and Avoiding Inflation’, Journal of Financial Economic Policy, Vol 4, Iss 1, pp.4 -24).

13 Responses to "Austerity Is Not Working: How to Restore Economic Growth"

  1. John Cardillo   May 1, 2012 at 2:13 pm

    For all those who believe that austarity is the answer and debt is evil, ask yourselves this: What would happen to the economy if everyone (public and private ) paid off all of their debt.

    The answer by definition of money, how it is created and what it represents is that the economy would stop (GDP=0). It is "Legal tender for all debts, private and public". It is a a universally trusted IOU.

    • LCR   May 1, 2012 at 3:50 pm

      Not all debt would need to be paid off. It is debt in certain areas of the economy (and leveragd debt of course) that fosters nothing in growth and runs the risks. This debt threatens the real growth which is needed to sustain a country. How one defines "real growth" will vary, but generally it has to come from the materials Mother earth gave us. The idea that social programs (which is what fiscally hurts most develped countries in the long run) can provide that which an economy can not produce is crazy. The idea that a house price will rise forever faster than wages is crazy. Yet this became leveraged debt. This type of deficit spending is always unsustainable. Confidence and "trust" has to be earned. In order to gain trust again deleveraging has to occur, or else capital will be at great risk.

  2. ali agaoglu   May 1, 2012 at 3:39 pm

    Dual currency in a single economy never works!
    How 'bout Method d: Restructure the debt, apply a reasonable haircut, (some banks will bankrupt, save the viable onesas government, let the others to fail) start from a "new normal" level?

  3. Marco Tizzi   May 1, 2012 at 4:33 pm

    Richard,
    this double-currency solution is so easy, so clearly working and so smart that it will never be accepted.
    Maybe you didn't understand the real goal of this whole thing: european technocrats want to make people poor so that it's easier for them to rule.

    • LCR   May 1, 2012 at 8:58 pm

      Can you say Rothchilds?

      • Marco Tizzi   May 2, 2012 at 6:57 am

        Any difference? :)

  4. buzz   May 1, 2012 at 11:27 pm

    Austerity can work if it's aggressive and front-loaded. Ireland, Latvia and Iceland could be sustainably recovering already if the rest of Europe wasn't plunging into recession. The key is to get all the cuts that will be necessary out of the way as quickly as possible, taking into account the fall in tax revenues and rising safety net and deposit insurance demands. Generally spending must be cut by about 1.5x the intended deficit reduction, depending on circumstances. It's painful but it does work.

    Where Europe is going wrong is by imagining that austerity is more easily absorbed when spread out over several years. This creates the seemingly endless downward spiral that the author is describing.

    The alternatives to austerity aren't nearly as well understood. For the theory that public deficits should be maintained as large as they need to be to compensate for increased private net lending, we have really only one example in history, that of Japan. Richard Koo thinks it worked better than austerity would have. I'm not so sure.

    Legislatively forcing the private sector to reduce wages and prices? Good luck, and in any case won't solve the need to cut public spending.

    The central bank funding big deficits indefinitely? I don't want to say that the various nasty hyperinflationary precedents apply in our electronic money world, so I'll just say the idea is untested.

  5. rodeneugen   May 1, 2012 at 11:43 pm

    One currency, two currencies, too much monetarism. The European economy needs fiscal stimulus and releasing all the obstacles, that prevent competition to happen and chance for fair employment from the new generation to be economically active. Let the young enter the economic circle and you will see the results immediately. 50% unemployment among the youth is more than any society can bear. At the end they will crucify us the veterans and justly.
    As to fiscal stimulus i have a proposition;
    Finally it started to be understand, that economic growth needs additional demand. Since the growth in demand from the rest of the world is rather sluggish, or at least not strong enough to compensate for the reduction in the demand of the G.I.P.S.I. countries, this additional demand has to be created within the European Union. It has to come from the countries with relatively low debt and potentially high perspective of economic growth. Clearly the best candidates are the Eastern European countries, with about same population as the G.I.P.S.I. countries. These countries have relatively low public dept, mostly bellow 50%, (except of Hungary), on the other hand relatively low standard of living and big deficit in infrastructure. If to start to create demand it should be in these countries, namely Poland, Romania, Czech Republic, Slovakia and Bulgaria. It is time to allocate financial resources within the EU, to where they are mostly needed and where they will create the highest yields and effect. A very good example for infrastructure project is the railways in these countries. While in France and Germany the trains are running at speed of 300 Km/hour and more, in Czech Republic at average it is 80 km/hour, (This is if they keep the schedule, what to my personal experience they don't). This is why there is no reasonable train connection between Berlin to Wiena, distanced about 700 km, that takes today 10 hours with train, or Berlin to Budapest, distanced about 900, that takes 12 hours. Even Berlin to Prague that is about 400 kilometer takes 5 hours. Just try to calculate the economic contribution of a train with double or triple speed could have. Berlin – Wien for 3 hours and Berlin – Budapest 4 hours, what a relive and increased efficiency it would be to the traffic between these cities. And the same can be said about Berlin – Warsaw, Warsaw Prague, etc. I know in all this post communistic countries the railways remained in the state of art and management systems of the previous regime. Here is a challenge, that Brussels could cope with, financing the project and encouraging structural changes in the railway companies. Buy the way it could be implemented in whole EU. Trains are environmentally less harming than airplanes, and for this distances less time demanding. By the way, the Chinese had done just this in the last 5 years and even for bigger distances. Let's learn for once from them.

  6. douglas ungredda   May 7, 2012 at 8:03 pm

    You are not getting the core of the rgument. every country has opted precisely for "all of the abov" answer . The issue at stake is how not to shrink ones tax base is in a post keynesian world. The tax base is shrinking due to cannibalization among Eropean competing governments eager to grab a piece of a fast shrinkng tax revenue pie. All this tahnks to fiscal heavens, communicaion technology making easier to do usiness in tax free havens and so forth .
    It was simply hilarious seeing Sarky and Hollande arguing on imposing wealth taxation . trhen sarkozy interupted Hollande just to make a pont that Spain modified the tax rates on the wealthiest a couple of years ago . So goes for the Tobin tax proposal which G Britain is clearly against preserving his turf. Many exmples can be cite but in the end the ECB will have to print aditional euros if an equitable solution for all sn worked out fast.

  7. Eric Verhulst   May 8, 2012 at 1:38 am

    The root cause of the problem is excessive money creation (by debt), so let's not throw more oil on the fire. This has created a mismatch between the money circulating and the value creation in the economy. Some day this excessive money has to come down to earth again.
    In order to really stimulate the economy, cost of doing business has to come down, mainly labor costs. The latter also increases the cost indirectly, e.g. when purchasing services. For this to happen, taxes have to go down. These taxes feed an excessive and inefficient bureaucratic machine and that is sucking away not just labor talent but also a lot of the investment potential out of the (private) economy where real value creation is happening. In Belgium for example 1/3 works for the government and another 1/3 lives from some form of benefits. This situation is not sustainable.
    The solution is therefore clear: cut the operating costs of the public sector with 30 to 50% and bring it back to reasonable levels. The problem is not that economies are not spending enough (we have credit fueled over-consumption) but that the resources are inefficiently spent at the countries' level. Of course, this is not an easy political solution. But if not done, the system will collapse (just like the Sovjet-Union did) and it will happen anyway. Just more painful than when action is taken now.

  8. Robert P. Coutinho   May 9, 2012 at 8:40 am

    In order for government-owned debt to come down, private levels of debt must go up or the net savings of the private sector must drop. This is not an opinion, it is a reality. Meanwhile, far too few politicians and (apparently) central bankers really understand how money is created. Look up Modern Monetary Theory to get a good idea of what really happens. The author has just suggested one of the parts of MMT.

  9. Nathan Pohlman   May 25, 2012 at 9:11 am

    "In order for government-owned debt to come down, private levels of debt must go up or the net savings of the private sector must drop. This is not an opinion, it is a reality. "

    Where does capital come from if private sector savings goes down? Oh yeah, you are probably for the government controlling and creating everything through that wonderful bubble creating Federal Reserve. Crony capitalism and out of control government spending is what has created this whole mess all over the world. People need to let real capitalism work… that old system that built the biggest economy in the world where people saved money and then invested in good ideas of their neighbor and then shared in the successes and failures. Oh yeah and don't forget the whole concept of letting bad businesses fail and good ones rise up to take their place.