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).