Nouriel Roubini's Global EconoMonitor

Fiscal Follies

From Project Syndicate

The fiscal stimulus that most advanced economies and emerging markets implemented during the 2008-2009 global recession – together with monetary easing and the backstopping of the financial system – prevented the Great Recession from turning into another Great Depression in 2010. At a time when every component of private demand was collapsing, the boost from higher government spending and lower taxes stopped the global economy’s free-fall and created the basis for recovery.

Unfortunately, stimulus spending and the related bailout of the financial system, together with the recession’s effect on revenues, contributed to fiscal deficits on the order of 10% of GDP in most advanced economies. According to the International Monetary Fund and others, these economies’ ratio of public debt to GDP will surpass 110% by 2015, compared to 70% before the crisis. Aging populations in most advanced economies imply additional public debt in the long term, owing to non-fully-funded pension schemes and rising health-care costs.

Thus, in most advanced economies, deficits need to be reduced to avoid a fiscal train wreck down the line. But much research, including a recent study by the IMF, suggests that raising taxes and reducing government spending has a negative short-term effect on aggregate demand, thereby reinforcing deflationary and recessionary trends – and undermining fiscal consolidation.

In an ideal world, where policymakers could credibly commit to medium- to long-term fiscal adjustment, the optimal and desirable path would be to commit today to a schedule of spending reductions and tax increases, phased in gradually over the next decade as the economy recovers. That way, if the economy needed another targeted fiscal stimulus in the short run, financial markets would not respond by driving up borrowing costs.

Unfortunately, the fiscal policy currently adopted by various advanced economies deviates sharply from this path of credible medium-term consolidation combined with short-term additional stimulus.

In the US, we have the worst of all possible worlds. On one hand, stimulus had become a dirty word – even within the Obama administration – well before the Republicans’ mid-term election victory ruled out another round altogether. On the other hand, medium-term consolidation will be all but impossible in America’s current atmosphere of hyper-partisanship, with Republicans blocking any tax increase and Democrats resisting reforms of entitlement spending. Nor is there any pressure from bond markets to concentrate the minds of policymakers.

In the periphery of the eurozone, the problem is the opposite: bond vigilantes are demanding that Greece, Ireland, Portugal, Spain, and Italy front-load fiscal consolidation or watch their borrowing costs go through the roof, risking them their market access and triggering a public-debt crisis. Markets don’t care that front-loaded fiscal consolidation is exacerbating recession and thus making the goal of reducing debt and deficits as a share of GDP near-impossible to achieve.

To avoid a persistent and destructive recession, the fiscal and structural reforms imposed by the bond vigilantes should be accompanied by other euro-zone policies that restore growth and prevent vicious debt dynamics. The European Central Bank should ease monetary policy in order to weaken the value of the euro and bootstrap the periphery’s growth. And Germany should cut taxes temporarily – rather than raising taxes, as planned – in order to increase disposable income and stimulate German demand for the periphery’s goods and services.

Alas, neither of the two biggest players in the euro zone is pursuing policies consistent with restoring sustained growth in the euro zone’s periphery. The ECB’s monetary policy is too tight; and Germany is front-loading fiscal austerity. Thus, the periphery is destined to a destructive deflationary and recessionary adjustment that will exacerbate the risks of recession, insolvency, eventual defaults and, possibly, exit from the euro.

In the United Kingdom, the new government gave several reasons for front-loading fiscal consolidation. The bond vigilantes might have woken up if early austerity was not implemented; the deficit was very large and the public sector bloated; and it is always politically easier to implement tough measures early in an administration, when popular support is still high and the next election is far off.

Certainly, the UK was playing with fiscal fire and needed some commitment to earlier austerity. But phasing in austerity more gradually, and thus back-loading the adjustment, would have posed less risk to the economy’s anemic recovery while maintaining a credible commitment to fiscal consolidation. Instead, the government could well end up with no plan B in case plan A – massively front-loaded austerity – leads to a double-dip recession.

In short, an optimal path of fiscal austerity would, in most countries, imply a back-loaded but credible commitment to medium-term consolidation, together with short-term additional stimulus when necessary and allowed by market conditions, thereby avoiding the prospect of a deflationary and recessionary spiral. Unfortunately, the main advanced economies are following a divergent path – which, in some cases, will lead them in the opposite direction in 2011. As a result, the risks of debt deflation and eventual disorderly sovereign and private-sector defaults are rising.

Nouriel Roubini is Chairman of Roubini Global Economics (, Professor of Economics at New York University’s Stern School of Business, and co-author of Crisis Economics.

7 Responses to “Fiscal Follies”

rogaDecember 13th, 2010 at 1:24 pm

What does it mean for the economy that no one comments on Dr. Roubini’s posts the way they used to back when you didn’t need to sign in to read his thoughts committed to the internet.

economicminorDecember 14th, 2010 at 12:25 am

There was once a large community of posters that would comment endlessly on both what Dr Roubini would write and endless on other sometimes painful and circular thoughts. Today many of the Dr.’s posts go with out even one single comment.I don’t know if this was his intention when he changed the blog but whether or not, he is the loser as no one has perfect thoughts. Without the diversity, everyone gets wrapped up in circular thinking where the input justifies and strengthens already believed conclusions. Not a good way to be if you are trying to stay ahead of the pack and be an innovative thinker.I have grown to believe that the fiscal stimulating and attempts at manipulating the economic system will prove worse than useless. There is an old axiom about throwing out all the improbable and what you are left with is the truth. I have been trying to do that and I have come to some tentative conclusions. One is that when the servicing of debts becomes to onerous, it is like when a parasite steals to much from its host. The host dies and then so does the parasite.Another is that government can encourage the growth of value added enterprise but can not create value itself. So deficit spending on supporting consumption will do nothing except create more debt to be serviced at a time when we already have more than can reasonably be paid.The system is so over loaded with overhead costs that it can not function. I have read and seen different figures but the low end is that the cost to the system for servicing debt is above 20%. When you take the consequence of taxation (income, property, excise, fuel, fees and other costs the government imposes on society) of around 50% (some say more like 60%). Anyway these together take 70-75% of a person’s income. This sure doesn’t leave much to pay for food, shelter, clothing, transportation and entertainment does it. No wonder so many, including the government, have turned to using additional debt to fill in the gaps.Is this sustainable? No.The only real answer to these problems is to write down enough debt so that there is excess capacity back in the system. Also remove enough of the cost of government to also reduce overhead to the productive sectors. I believe this will happen either thru conscience decisions or thru the chaos of economic catastrophe. Either way it will happen. I prefer the first but so far see absolutely no signs of movement in this direction.Are any of you trained in science? Chemistry? Physics? Math? Do you understand the concept of a balanced equation? Every action has an opposite and equal reaction. Sometimes it takes time for these affects to balance but they always do. Why is it that people expect the financial world to operate outside the laws of nature?Dr Roubini and the US government want to pretend that adding more adrenalin to a patient with a severe heart problem will make them healthier. When what the patient needs is rest then a long recuperation and all they get is additional stimulants… what do you think will be the results?

sDecember 14th, 2010 at 1:26 am

When what the patient needs is rest then a long recuperation and all they get is additional stimulants… what do you think will be the results?Apt metaphor.My guess: patient dies and “doctors” have to prey on each other.Another metaphor: they are remodelling the economic building by taking from the basis and adding to the top (taking from the basis in the form of more debt obligations and adding to the top in the form of increasing capital flows). What do you think will be the results?

economicminorDecember 14th, 2010 at 9:36 am

What is so frustrating is that for us the inverted debt pyramid is clearly visible yet for Dr Roubini and the neo Keynesians, their vision also seems clear to them. They just can’t see how their stimulus plan has only brought on more instability rather than financial healing. Dr Roubini seem so clear sighted about a lot yet doesn’t seem to be able to pull back far enough to actually see the bigger picture.Do you or have you visited Professor Steve Keen’s web blog? His work is historically based using math and computer graphics to show his work and conclusions. If not, I suggest that you check him out. Just google him. He is open to comments/questions and often answers questions himself. Some of his video presentations show via math/graphical what you and I believe.

hloweDecember 14th, 2010 at 10:47 am

Polar magnetic shiftChina will need to revalue their currency, resulting in U.S. inflation and more export jobs; this should help balance your equation. This time we will produce and export more, while they consume more.Perhaps hot money flow from QE will help expedite the polar shift before we collapse in debt (and print our way through misery) See China inflation rates.Tax policies also will need to change in order to facilitate saving and investment, but will this “can” continue to get kicked down the road? Or should U.S. wait for China to become more consumer oriented first?Will this be our way out?

sDecember 14th, 2010 at 11:07 am

Yes, I visit his blog on a regular basis, great ideas to find there.The elite doesn’t want to see the problem. It’s like they want to divide the world into bottom dwelling debt slaves and high flying capital suckers. The more debt there is around, the more capital they can suck (in their egotistic logic).I enjoyed this from ZeroHedge: The man who probably more so than anyone else can be singled out as the person (behind the scenes) responsible for the destruction of America, first with his successful drubbing of every vestige of regulation, then his isolation of Brooksley Born and her all too prescient concerns on structured products and derivatives, and finally, with carrying over his debilitating management practices from Harvard over to the US in general for the past two years, just had his farewell speech, which in typical fashion can be summarized as follows: “I am smarter than you peasants, go to hell.” didn’t vote for him, how could he get into that position? Beyond my comprehension.