You are here: Home Knowledge Base The Design of Fiscal Consolidation Plans Solutions The Answer to High Debt Is Growth
Symposium 2015

Solution for The Design of Fiscal Consolidation Plans

The Challenge

In the aftermath of the global financial crisis and the Great Recession, many countries are facing substantial deficits and growing debt. As analyzed in the 16th Geneva Report on the World Economy, th ...

In the aftermath of the global financial crisis and the Great Recession, many countries are facing substantial deficits and growing debt. As analyzed in the 16th Geneva Report on the World Economy, the global debt-GDP ratio continues to grow, while growth and inflation remain low, raising concerns about the dangers posed by new crises. This situation spurs the need to consolidate public finances in order to bring down debt-GDP ratios. When setting up specific fiscal consolidation plans in order to achieve this, policymakers can generally choose from a wide range of possible fiscal instruments. The aim of this session is to discuss how consolidation plans should be designed to bring debt-GDP ratios down, while minimizing short-run social and economic costs.

The Answer to High Debt Is Growth

Surely for Europe the problem is how to stimulate growth to bring down debt-GDP ratios. Fiscal austerity is unlikely to achieve that. Even the much-vaunted UK recovery is barely progress when measured by GDP per head. In fact it can be argued, as the independent UK Office for Budget Responsibility in effect did, that UK Conservative Chancellor of the Exchequer’s austerity in 2010 to 2012 actually stalled the fiscal consolidation which was occurring in the UK as a result of the stimulus which had been the previous Labor government’s response to the crisis. The UK saw the slowest recovery in a cycle since records began in 1838, and the UK still has a budget deficit of 5%, among the highest in Europe. Europe should not be tightening spending at this point, given such persistently high youth and general unemployment rates in a number of countries, and especially with China slowing.

Public infrastructure investment, low interest rates, and redistribution to encourage less debt-dependent demand is needed to get Europe going and to alleviate hardship.

Background: The fear of debt that begat more debt

Even seven years on from the crisis, Europe is failing to recover in any significant way and is also failing to tackle its big unemployment problem. A four-fold response to the 2008 recession was required:

  1. emergency measures to steady the finance markets,
  2. short-term demand-side measures to pump-prime economies out of recession,
  3. medium-term policies to mend the revealed weaknesses in the banking sector,
  4. and long-term structural reforms for growth.

 

In reality policy was only effective on the first point. Policy has been incoherent on the second point, even for the richer countries, and with intolerable burdens of fiscal adjustment placed on countries whose growth is too weak to carry that adjustment. Policy is still to be really tested on the third point, and so far policy has been impotent on the fourth point. The result has been years of near-stagnation, and now our economic prospects are heading downwards. In the Eurozone slow growth of 0.4% in the first quarter has fallen to 0.3% in the second quarter, with just about every country falling short of expectations (http://uk.businessinsider.com/eurozone-gdp-q2-2015-2015-8). Even with favorable tailwinds from much cheaper oil, a cheaper Euro, bond buying by the ECB, and continuing world growth, the European Commission’s latest forecast has been for the EU economy to expand by 1.8% this year, only slightly faster than the 1.4% achieved last year, and to expand by 2.1% in 2015. While this is some improvement, this follows years of near stagnation. And within the EU, the Eurozone is expected to grow even more modestly, by 1.5% this year after just 0.9% in 2014, and then by just 1.9% in 2016. And these projections were made before the Greek crisis in the summer. That crisis sent shock waves across the European countries, and that crisis has accompanied more recent turmoil in China. World growth which is meant to sustain the European forecasts may therefore be lower and any positives will have to look at oil and commodity prices remaining weak for longer and the long expected rise in interest rates to be postponed for a while. And in the meantime debts worldwide remain unsustainably high, including in China.

It was all meant to be so different. In Europe in particular, bringing down national debt was meant to revive the “confidence fairy” whereby a renewed spurt of private investment would spontaneously return us to growth. Instead, private EU investment has plunged by some €400 billion, but in response to proposals for fiscal stimulus to plug this investment gap and shore up demand, we were told that we couldn’t “spend our way out of debt.” We were told that unless we tightened our belts and suffered, high debt levels would forever drag us down. Some even told the fairy tale that it was public spending that had got us into this mess in the first place. So Europe eschewed anticyclical fiscal spending in favor of procyclical fiscal consolidation, relying instead on experiments in monetary expansion, as we scraped along the interest rate floor. The fatal error was to confuse the tail with the dog; public finances are generally an outcome of the health of the economy and are not in themselves its health. Public debt naturally goes up as the economy falls, by way of automatic stabilizers, so when the economy collapses as it did in a number of cases in Europe, debt goes up significantly. This automatic debt response is a good thing, not a bad thing, since to get the debt back down the economy would have to grow. That often requires injecting demand back into the economy through a budget deficit. Debt in the EU as a whole reached 88.6% of GDP last year. And given in particular the way the various bailouts in the Eurozone worked, and the impact of these bailouts on the economy, it is hardly surprising that in the Eurozone the debt-GDP ratio is expected to have peaked at 94.2% last year (Spring 2015 Economic Forecast, European Commission).

Whether that will represent the peak remains to be seen. Much will depend on the rate of GDP growth. In fact, history shows that GDP growth, helped by a little inflation, is the tried and tested way of reducing debt to GDP ratios (see, for example: <https://static1.squarespace.com/static/541ff5f5e4b02b 7c37f31ed6/t/5538ed0de4b01a0f9e18c48d/1429794073737/The+Consequences+of+Fiscal+Stimulus+on+Public+Debt.pdf>). Engaging in fiscal consolidation through austerity is the proven way to prolong high debt to GDP ratios, stretch-out recessions, create social stress, and inflict pain on the masses. The recent UK experience gives a neat case study in this. As the strong stimulus from 2008 worked through the economy, the UK’s public sector net borrowing fell sharply. It then flat-lined as Mr. Osborne’s 2010 austerity starved the recovery of demand. As it is now widely acknowledged, by 2012, the Chancellor lost his nerve as the elections were coming up on the horizon. He quietly backed-off on austerity and this has allowed the ratio to begin to fall again (“Its the Economy, Stupid,” by Pryce, Ross, and Urwin, 2015, Biteback Publishing).

The Solution: Growth whatever it takes?

The type of growth achieved by fiscal policy must be the “right” type of growth. Initiatives such as the European Fund for Strategic Investment Europe (EFSI), known as the “Juncker Plan,” at least recognize the problem as lack of demand. Of course it is only sensible to attempt to mobilize the vast reservoirs of moribund private finance, but there is still space, both economic and legal, for new ECB/EIB and other credit to expand public infrastructure investment. Furthermore, ECB “debt” is not really debt and is, hence, not a problem for Europe for the foreseeable future. Indeed, as it is not real debt it most likely will never need to be called in. The real dangers today are deflation and zero-lower bound traps, not inflation, and the productive capacity that ECB can finance now could be a free gift forever.

We still need Quantitative Easing (QE) (which should have come much earlier in the Eurozone) and low interest rates. But, in nations such as Greece, ongoing deflation means that the public sector, citizens, and businesses are facing high real interest rates at a time when fiscal retrenchment has serious repercussions on the economy. Further QE operations of course can help, especially as they vacuum up sovereign debt, allow countries to continue to have viable banking systems, and also help to finance public services. QE should continue for as long as possible and not be reversed for a long time, if ever. In addition, specific actions such as lengthening maturities and lowering interest rates on legacy debt for countries with unsustainable debt levels reduce the costs of servicing those debts. This also lessens the need for austerity. There have been suggestions to introduce bonds with interest rates linked to achievable growth rates, or for so called “perpetuity” bonds that get constantly rolled over but never get repaid. There have also been calls for increased mutualization—in other words, risk sharing across nations—by issuing collective “Eurobonds,” for example, up to a certain debt to GDP ratio for each country that may be considered “sustainable.”

But the main aim of all this is to set up the conditions to allow countries to achieve faster rates of economic growth. In the face of too little growth in many countries (not only Greece and Portugal but Italy and France, for example), we should be adding more fiscal stimulus. But it should all be put to good use, not for current spending but for public investment. That is, if projects are well-chosen. Here, we may have more faith in the EIB and EBRD than the EC. Furthermore, public infrastructure has a good rate of return with respect to growth, and we should take advantage of historically low interest rates. In addition, financing for SMEs to encourage them to survive, grow and innovate, is a must. So is encouraging surplus nations to spend more. To accomplish this, for the Eurozone itself, there should be proper transfers of funds to rebalance economies and lead to the convergence.

The benefits from this proposal are spread across most socioeconomic groups and the region’s economy as a whole. The obstacles to implementing the proposal are more ideological than practical, and these obstacles need to be overcome. The economics of this proposal is clear but the implementation needs to be done efficiently and with purpose. Otherwise, individual nations will waste the opportunity. In the European context it will require for technocrats in European institutions to work together and in close and equal collaboration with locals, to find the right solutions. Together they will need to focus on reforms to increase growth, be those solutions regional (competition policies not up to scratch/ individual countries not prepared to look beyond their borders and rebalance their own policies) or local (too much bureaucracy, too large an influence of a small group of individuals/firms, too much corruption). A focus also needs to be on the rebuilding of skills for people who have been out of the workforce for too long as a result of the crisis (the phenomenon of “hysteresis”).

The proposal is not new. There are no magical solutions as such. But what is new is the urgency with which the proposal must be pursued. The banking system which is only just being cleaned up, albeit too slowly for some, will not be able to withstand another shock, external or internal. Capital, which has been grossly misallocated through most of the Euro’s existence, needs to now be directed into productive uses. Without a proper financial system to support economic activity and assist entrepreneurship, the Eurozone would risk being stuck in a limbo of low growth, high unemployment, low investment and innovation, and increasing inequality. All of these things will negatively affect economic conditions for a long time to come. And without a return to faster growth, debt will remain a problem rather than being contained; in fact, debt will be truly rendered unsustainable, which will put a constraint on growth.

    Related Solutions

    Solution
    Symposium 2015

    Reconcile Fiscal Consolidation with Economic Growth and Social Inclusion

    Reconcile Fiscal Consolidation with Economic Growth and Social Inclusion

    Reconcile Fiscal Consolidation with Economic Growth and Social Inclusion

    Solution
    Symposium 2015

    On the Design of Fiscal Consolidation Plans

    On the Design of Fiscal Consolidation Plans

    On the Design of Fiscal Consolidation Plans