Transcript austerity vs. stimulus

Current Issues in Economics
Policy response to crisis
Austerity vs. stimulus
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Current Issues in Economics
Overview
• Knowledge and social capital as production
factors
• Internet Economics
• Labor markets in the time of robots, aging
societies, and new era of inequality
• 4th Industrial Revolution or Secular Stagnation
• Policy response to crisis : austerity vs.
stimulus
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Great Moderation
• From the early 1980s on, most advanced economies
experienced what has been dubbed the “Great
Moderation,” a steady decrease in the variability of
output and its major components— such as
consumption and investment.
• There were, and are still, disagreements about what
caused this moderation.
– Central banks would like to take the credit for it, and it is
indeed likely that some of the decline was due to better
monetary policy, which resulted in lower and less variable
inflation.
– Others have argued that luck, unusually small shocks
hitting the economy, explained much of the decrease.
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Impact of policy worldview: Washington Consensus
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Fiscal policy discipline, with avoidance of large fiscal deficits relative to GDP;
Redirection of public spending from subsidies toward pro-growth, pro-poor
services like education, health care and infrastructure investment;
Tax reform, broadening the tax base and adopting moderate marginal tax rates;
Interest rates that are market determined and positive in real terms;
Competitive exchange rates;
Trade liberalization: liberalization of imports, with elimination of quantitative
restrictions (licensing, etc.); any trade protection to be provided by low and
relatively uniform tariffs;
Liberalization of inward foreign direct investment;
Privatization of state enterprises;
Deregulation: abolition of regulations that impede market entry or restrict
competition, except for those justified on safety, environmental and consumer
protection grounds, and prudential oversight of financial institutions;
Legal security for property rights.
In practice: "Stabilize, privatize, and liberalize"
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Impact of growing complexity
• Institutions: Banks are only part of a complex network
of financial institutions and markets, and risks are far
from gone.
• Financial products: When the U.S. housing boom
turned to bust, a complex and opaque structure of
financial products led to confusion which institution
was holding which claims and which institutions were
solvent.
• This in turn led to major liquidity runs, not so much on
banks, but on many nonbank financial institutions,
such as investment banks—many of which over the
years operated like banks but without the regulation
and protections banks received.
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Impact of regulatory system
• Markets, having been progressively deregulated since the
1970s, were confronted by a particularly fragmented and
ineffective system of government prudential oversight.
• The reality of financial regulation is that new rules open
new avenues for regulatory arbitrage, as institutions find
loopholes in regulations. That in turn forces authorities to
institute new regulations in an ongoing cat-and-mouse
game (between a very smart mouse and a less nimble cat).
• Global regulatory arbitrage. Hoping to reduce their
required regulatory capital under the Basel II framework,
European banks eagerly acquired AAA-rated (but
systemically risky and opaque) structured products.
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Unfolding post-crisis drama
Years after the global crisis erupted, the world’s
mature economies find themselves with
shockingly fragile economies, and weak signs of
recovery
• US
• Eurozone
• Japan
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Roots
• In US crisis originated from private financial
sector but with monetary (low interest rates)
and mortgage guarantees encouragement
from the state
• In Europe, causality mostly flowing from
public to private
• In Japan, demographics
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Hope of soft landing
• The ability to finance macroeconomic
imbalances through easy foreign borrowing
allowed to postpone tough policy choices.
• Investors’ appetite for public debt that turned
out to be toxic provided one ready source of
external funding of the deficit.
• At the same time, countries with current
account surpluses (first of all China) faced
minimal pressures to adjust.
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Austerity
• Austerity describes policies used by governments
to reduce budget deficits during adverse
economic conditions. These policies may include
spending cuts, tax increases, or a mixture of the
two.
• Austerity policies to demonstrate governments'
fiscal discipline to their creditor and credit rating
agencies by bringing revenues closer to
expenditures; they may also be politically or
ideologically driven
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Stimulus
• Stimulus refers to attempts to use monetary and/or
fiscal policy to stimulate the economy.
• Fiscal stimulus refers to increasing government
consumption or transfers or lowering taxes. Effectively
this means increasing the rate of growth of public debt
except that particularly Keynesians often assume that
the stimulus will cause sufficient economic growth to
fills that gap partially or completely.
• Monetary stimulus refers to lowering interest rates,
quantitative easing, or other ways of increasing the
amount of money or credit.
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US choice
• Quantitative easing (QE) is an unconventional
monetary policy used by a central bank to stimulate an
economy when standard monetary policy has become
ineffective.
• A FED implements quantitative easing by buying
specified amounts of financial assets from commercial
banks and other private institutions, thus raising the
prices of those financial assets and lowering their yield,
while simultaneously increasing the monetary base.
• This differs from the more usual policy of buying or
selling short-term government bonds in order to keep
interbank interest rates at a specified target value.
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FED QE Expansion
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Euro-zone decision space – public debt
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Euro-zone decision space
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High public debt
Euro
European Central Bank
National governments
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Austerity assesment
• According to IMF, the quantitative easing policies
undertaken by the central banks of the major
developed countries since the beginning of the
late-2000s financial crisis have contributed to the
reduction in systemic risks
• The QE policies also contributed to the
improvements in market confidence and the
bottoming-out of the recession in the second half
of 2009.
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Euro-zone turn&twist response
• „Not our problem”
• In 2009, ECB said that it would focus on buying covered
bonds, a form of corporate debt. It signalled that its initial
purchases would be worth only about €60 billion.
• In a dramatic change of policy, on 22 January 2015,
President of the ECB announced an 'expanded asset
purchase programme': where €60 billion per month of
euro-area bonds from central governments, agencies and
European institutions would be bought. Total QE of at least
€1.1 trillion. Mario Draghi announced the programme
would continue: to do “whatever it takes” to save the euro
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Japan policy space
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Japan: problems beyond fiscal
• The Japanese economy is contracting again,
caught in a debt-deflation vice. Growth has been
negative for four of the last eight quarters. What
was once a ‘Lost Decade’ is turning into a “Lost
Quarter Century” with no remedy in sight.
• The underlying problem is that Japan’s trend
growth rate has fallen below zero as baby
boomers retire and demographic crunch worsens.
“This is something neither monetary easing or
fiscal stimulus can rectify”
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Abenomics
• The economic policies advocated by Shinzō Abe
since the December 2012 general election, which
elected Abe to his second term as Prime Minister
of Japan.
• Abenomics is based upon "three arrows" of fiscal
stimulus, monetary easing and structural
reforms.
• Designed to jolt the economy out of suspended
animation that has gripped it for more than two
decades
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Policy response
Response German way
Germany the main supporter of austerity and enemy of
stimulus
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Why austerity
Supporters of austerity • Fiscal stimulus is needed most when governments already have extra costs
to bear.
• From 2007 to 2010 rich countries saw the ratio of their gross sovereign
debt to GDP spike from 74% to 101% on average.
• British public debt jumped from just 44% of GDP to 79%, while America’s
leapt from 66% of GDP to 98%.
• Greece’s soared by 40 percentage points, to 148% of GDP
Stimulus a bomb with delyaed action:
• Inflation
• Crowding-out private activites
• Costs for future generations
• Slippery slope for public spendings
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Why stimulus
• Supporters of stimulus looked to the ideas of Keynes. Depression occurs
when too many people want to save and too few to invest, then resources
(including workers) fall idle. Firms and families might save too much
because of financial uncertainty or because they are rushing to
“deleverage”—to reduce the ratio of their debts to their assets.
• When there is slack in the economy, fiscal stimulus can be particularly
powerful thanks to a “multiplier” effect. A dollar spent building a railway,
for example, might go to the wages of a construction worker. He then
spends the extra income on groceries, enriching a shopkeeper, who in turn
goes shopping himself and so on
• In normal times central banks would try to spur growth by adjusting
interest rates to discourage saving and encourage borrowing. Yet by early
2009 most central banks had reduced their main interest rates almost to
zero, without the desired result. Over indebtedness, have been preventing
people from borrowing as much as they would like, whatever the interest
rate.
• Governments needed to make up for firms and families, by borrowing and
spending more (or taxing less) to put excess savings to work.
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Policy vs. Politics
• A procyclical fiscal policy piles on the spending and tax
cuts on top of booms, but reduces spending and raises
taxes in response to downturns.
• Budgetary profligacy during expansion; austerity in
recessions.
• Procyclical fiscal policy is destabilising, because it
worsens the dangers of overheating, inflation, and
asset bubbles during the booms and exacerbates the
losses in output and employment during the
recessions.
• In other words, a procyclical fiscal policy magnifies the
severity of the business cycle.
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How deep cuts?
• In 2009 many countries rolled out big
packages of tax cuts and extra spending in the
hope of buoying growth.
• This stimulus amounted to 2% of GDP on
average among the members of the G20 club
of big economies but much more for some,
smaller economies
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Multiplier effect
• Sceptics - it would be low, and that neither stimulus nor
austerity would have much effect on output or jobs.
Stimulus simply absorbs resources that would otherwise
have been used by private firms. Firms and households
would probably save their share of the proceeds, rather
than bolster the economy by spending them, since they
would assume that it was temporary.
• Optimists -ith unemployment high and private demand for
loans low, there was little risk that the government would
“crowd out” private activity. Indeed, with indebted
households forced by falling asset prices to pay off loans
quickly, a boost to incomes from a fiscal stimulus would
speed the financial adjustment, and thus generate a faster
recovery.
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Austerity: social consequences
• In many cases, austerity measures have been
associated by critics with a decline in living
standards and have led to popular protest.
• The financial crisis—particularly the austerity
package put forth by the EU and the IMF—was
met with great anger by the Greek public,
leading to riots and social unrest
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Stimulus temptation
As growth returned in 2010 some leaders
argued that it was time to trim public spending.
Others worried that the recovery was too fragile
to permit any hint of austerity.
There was no question that “fiscal
consolidation” would eventually be necessary,
but much dispute about when it should start.
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So, is austerity/stimulus good or bad?
• It is a wrong question. When an economy is in a boom, the
government should run a surplus; other times, when in recession, it
should run a deficit.
• Many politicians in the developed countries live by procyclicality.
They argue against fiscal discipline when the economy is strong,
only to become deficit hawks when the economy is weak.
• Historically, developing countries used to be the ones where
dysfunctional political systems produced procyclical fiscal policies
during 1960-99. But things have changed. Remarkably, during the
decade 2000-10, about a third of emerging market governments
took advantage of the boom years 2003-7 to strengthen their
budget positions, saving up for a rainy day. They were thus in a
good position to ease up when the global recession hit them in
2008-9.
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Beyond financial crisis
• Today, global economy faces both lack of
demand as consumers continue to reduce
debt as well as structural barriers on the
supply side due to lack of investment in
human and physical capital, which has limited
economic potential
• There has been a misallocation of capital due
to a period of artificially low interest rates.
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Deeper roots
• The debate is not about the need for fiscal
discipline.
• In advanced countries, with an aging population
and rising healthcare costs, the large expansion
of debt due to the crisis is an unwelcome addition
to the fiscal burden, and requires a convincing
policy response.
• Rather, the debate is about the extent to which
spending cuts and tax hikes in the short run are
desirable and effective in containing the prospect
of sovereign risk crises.
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IMF U-turn
Most recently, however, capitalism has been
characterized by “excess”—in risk-taking,
leverage, opacity, complexity, and
compensation. It led to massive destruction of
value. It has also been associated with high
unemployment, rising social tensions, and
growing political disillusion – all of this
happening in the wake of the Great Recession.
Christine Lagarde Managing Director,
International Monetary Fund, 2014
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Need for balanced approach
• IMF managing director in August 2011, "For the advanced
economies, there is an unmistakable need to restore fiscal
sustainability through credible consolidation plans. At the
same time we know that slamming on the brakes too
quickly will hurt the recovery and worsen job prospects. So
fiscal adjustment must resolve the conundrum of being
neither too fast nor too slow. Shaping a fiscal consolidation
is all about timing. What is needed is a dual focus on
medium-term consolidation and short-term support for
growth. That may sound contradictory, but the two are
mutually reinforcing. Decisions on future consolidation,
tackling the issues that will bring sustained fiscal
improvement, create space in the near term for policies
that support growth”
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Mix of long-term short-term measures
• Strategies that involve short-term stimulus with
longer-term austerity are not mutually exclusive.
• Steps can be taken in the present that will reduce
future spending, such as on pensions by reducing
cost of living adjustments or raising the
retirement age for younger members of the
population,
• while at the same time creating short-term
spending or tax cut programs to stimulate the
economy to create jobs.
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Lesson from history (that there are no lessons)
• For the first time since the 1930s, the world is suffering from a
persistent lack of adequate demand; people just aren’t spending
enough to make use of the productive capacity we have. This was
supposed to be a solved problem, one that may have bedeviled our
grandfathers but wasn’t going to come back.
• Economists thought we had macroeconomic policymaking under
control. Demand management was assigned to technocrats at
independent central banks while fiscal policy focused on long-run
issues. In the face of large, sustained shocks, however, it turns out
that this system breaks down. On one side, central banks are
constrained both by the zero lower bound—the fact that interest
rates can’t go negative—and by concerns over the size of their
balance sheets. On the other, fiscal policy, far from helping, quickly
began making things worse.
• Elizabeth II to economists: „why nobody told me?”
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Austerity vs. stimulus
Conclusions
• The world is still seized by a debate between fiscal
austerity and fiscal stimulus. Opponents of austerity
worry about contractionary effects on the economy.
Opponents of stimulus worry about indebtedness and
moral hazard.
• Have the austerity programs adopted by countries
been cutting too much and too soon?
• Has austerity triggered a self-defeating ‘doom loop’
whereby budget cuts and tax rises widen deficits by
throwing economies into tailspins?
• Is spending more by increasing public debt a solution?
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Heretic view
• How fiat is fiat money?
• How selective can be policy in the time of the
big data?
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