The debate has finally moved forward. There is growing official acceptance that austerity policies have failed.
Going forward, however, IMF forecasts show that Eurozone countries will continue to incur budget deficits into the future. All else equal, this means that public debt will continue to increase, year-by-year, particularly in periphery countries where budget deficits will remain relatively high.
The periphery countries now need to confront falling output and rising public debt. There is a growing consensus (including at the G-8 level) that a new economic plan is required. The general objective would be to turn these economies around, and to establish sustainable economic growth and create employment, without raising debt further.
To achieve these ends, policy orthodoxy must now be challenged. Governments require the advice of officials who have the broadest vision and understanding of macroeconomic policy issues. The conventional method of financing budget deficits ― new bond sales ― is no longer appropriate in countries with high public debt. In these countries, it will no longer be sensible for monetary and fiscal policies to be determined in separate silos. It is imperative that there is greater coordination between monetary and fiscal policies. Time is short, and, therefore, politicians and Ministries of Finance have a central role to play in establishing the new policy paradigm.
Economic policies need to be set within a medium-term framework. However, within that broad framework, there is a need for macroeconomic policies to achieve a shorter-term turnaround, from ‘austerity’ to ‘economic growth’.
In the medium-term there is a need for growth-supporting structural policies and medium to longer-term fiscal consolidation, and improved financial and banking sector oversight.
The greater challenge, however, is that of making the adjustment from ‘austerity’ to ‘economic growth’ ― without raising debt further ― in the period immediately ahead. There are limited macroeconomic policy options available to engineer this transition.
Elements of a plan to turn economies around
The macroeconomic plan outlined below could apply to any periphery country, whether it stays inside the Eurozone, or exits from the zone. Those countries that exit from the zone will have an additional tool ― the exchange rate ― to facilitate the required adjustments.
At the centre of the plan is a new policy paradigm to guide greater fiscal and monetary policy coordination.
For monetary policy there is a need to shift away from the current approach where the ECB creates new money so that it can purchase government bonds on the secondary market. This is a purely defensive policy which comes into play whenever the interest rates on sovereign government bonds rise above, say, 6 per cent. The current policy seeks to bring interest rates below 6 per cent. As forecast budget deficits will continue to add to debt levels going forward, this policy will be required year-after-year as interest rates rise again: it solves nothing, it merely kicks the can further down the road, endlessly.
In relation to monetary policy, there may be scope to lower the policy interest rates further in Europe, but as the policy rate is already very low the beneficial effects of that step may not be significant, particularly in periphery countries where risk premia are at their maximum tolerable bounds.
This then raises the question: what should be the role of monetary policy going forward? This question can only be answered by also simultaneously considering the role of fiscal policy. Monetary and fiscal policies need to be coordinated to re-establish economic growth without borrowing, and creating more public debt.
Given the abovementioned limitations on monetary policy, fiscal policy must play the main locomotive role. Fiscal policy needs to become stimulatory: budget deficits, above those planned for under austerity, are required.
However, if these higher budget deficits are financed by governments issuing new bonds then public debt will increase more than is currently forecast. This path would be disastrous, as it would lead to credit downgrades, on-going financial crises and default.
If the national governments (rather than the European Central Bank, as at present) created new money, then conceivably this new money could be used to directly finance the budget deficits. With fiat money there is no liability generated as new money is created. It follows that there would be no further increase in public debt. Debt levels would stabilise, immediately.
Consequently, the way forward is to provide economic stimulus through the budget and finance it through new money creation. National governments could do this alone (using their own national currency), or they could swap their own new national currency with the European Central Bank for euro, and use the euro to finance their budget deficits.
The task of financing the budget deficit cannot be achieved simply by asking central banks to print the new money. This is so because, to transfer the new money from the central bank to the government (to finance the deficit), the government is required to issue new government bonds to the central bank in exchange. This raises public debt as government bonds held on the central bank balance sheet are counted as public debt, as such bonds could be sold to the public at any time.
In addition to coordinated monetary and fiscal policies, a prices and incomes policy would desirably form part of the policy adjustment process. The objective of the prices and incomes policy would be to reduce wages and prices in required proportions to maintain adequate business profitability, and to establish improved cost competitiveness. This policy is needed because austerity will no longer be creating unemployment designed to lower wages and prices.
The European governments cannot afford to head down another blind alley. Great care is required to avoid on-going financial crises and restore hope for all Europeans, and the rest of the world.
Institutional arrangements and policies that were appropriate in the great battle against high inflation and high unemployment during the 1980s and 1990s are no longer relevant today, as the battle ground has shifted to high debt and high unemployment.
Today, a way must be found to generate economic growth and stop debt rising before it engulfs Europe in a major catastrophe.
Structural policies are needed to increase productivity and support growth over the medium to longer-terms, but structural policies could not generally be relied upon to lift demand in the shorter term. Sensible fiscal consolidation is required over the longer-term to lower public debt levels.
The German fear is that printing new money to finance the on-going deficits will lead to hyperinflation. This is somewhat inconsistent given German tolerance for the European Central Bank’s policy of creating new money to buy-up excessive sovereign debt, adding risk to the central bank’s balance sheet. If these hyperinflation fears persist, the governments of periphery countries, or the relevant central European authority, could impose strict legislative limits on the use of money creation to finance their budget deficits. More importantly, the only function of the proposed new money creation is to finance the budget deficit to stimulate the economy. Once that initial stimulus has been delivered the new money could be withdrawn from the economy if liquidity was judged excessive, and normal liquidity management resumed.
The plan outlined above provides a possible way forward.