Tuesday, July 9, 2013

Austerity Can Kill You

In 1962 the RCP (Royal College of Physicians) published a Report on Smoking and health  in the UK. Using research by Sir Richard Doll and Sir Austin Bradford Hill, the Report established conclusively the link between smoking - including passive smoking - and lung cancer, other lung diseases, heart disease and gastrointestinal illnesses. It caused a sensation, and received an ambivalent, often hostile response from the media, governments and society. In 1962 tobacco "smoking was omnipresent, accepted, established." "[In the UK] around 70% of men and 40% of women smoked". It was "a world suffocated by the swirling clouds of tobacco" - "in pubs, cinemas, trains, buses, on the streets, and even in hospitals and schools." [from the RCP-Royal College of Physicians report on Fifty years since Smoking and Health – progress, lessons and priorities for a smoke-free UK, 2012]. 

Gradually government action reduced this phenomenon.  By 2012 "... smoking is no longer the norm. Our schools, hospitals, pubs, cinemas and public transport are subject to smoke-free legislation. [In the UK] Only 21% of the population smokes. Government, media and society have largely accepted the need to protect people, particularly children, from much of the harm associated with tobacco smoke." Still, in the UK it took fifty years to achieve such a large reduction in smoking incidence. Smokers are still 21% of the population too many, they represent glaring evidence of either irrationality or addiction or both, and the persistence of vested interests by tobacco and cigarettes producers.

Austerity - aiming at a balanced government budget, reducing expenditure and raising taxation even in the middle of an economic recession - also has been the norm for a very long time, and still is enshrined in the statutory policies of EU and EMU, of IMF and ECB. Yet we have known at least since 1936 (with the publication of Keynes' General Theory), indeed since 1933-35 (the dates of Michal Kalecki's anticipations of Keynesian propositions, see Robinson 1976 and Nuti 2004) that austerity can cause unnecessary, involuntary unemployment of labour and irreversible losses of income and consumption.

In our time and age austerity is more incomprehensible than smoking, were it not for the irrational fear of inflation in the middle of a recession, the generalised addiction to hyper-liberal ideologies and the vested interests of those who think they benefit from labour unemployment keeping workers "in their place". What is worse, austerity today is much more widespread than smoking, it is on the rise and is officially supported by our national and international authorities more than it ever was, while at least smoking is steadily declining not least because of progressive health policies worldwide.

Feasible full employment

In 1943 Michael Kalecki could write that “A solid majority of economists is now of the opinion that, even in a capitalist system, full employment may be secured by a government spending programme, provided there is in existence adequate plant to employ all existing labour power, and provided adequate supplies of necessary foreign raw-materials may be obtained in exchange for exports”. As long, of course, as such government spending programme is “financed by borrowing and not by taxation”. Kalecki even dealt with the case of highly indebted countries, which also could afford and attract loans to finance government expenditure as long as interest was paid out of a capital levy.

Opposition to such a policy of full (meaning high and stable) employment would be political: "(i) opposition in principle to government spending based on a budget deficit; (ii) opposition to this spending being directed either towards public investment – which may foreshadow the intrusion of the state into the new spheres of economic activity – or towards subsidizing mass consumption; iii) opposition to maintaining full employment and not merely preventing deep and prolongued slumps”. Such objections subside in the slump, and are revived in the boom, thus generating what Kalecki called a "political cycle" and a generally lower average degree of employment over such cycle than otherwise feasible. 

But the feasibility of Kaleckian-Keynesian full employment policies soon ceased to enjoy the support of a "solid majority of economists". The effectiveness of expansionary fiscal policy was challenged on an escalation of arguments.

From deficit spending to expansionary fiscal consolidation

First, it was argued that government expenditure would “crowd out” private investment. This idea neglects the possibility of private investment on the contrary “crowding in” additional expenditure due to the activation of its accelerator effect of higher primary demand. On the contrary, Dennis Robertson (in a talk given at Princeton in 1953) argued that at least some of the additional savings out of the income generated by government spending would not represent a leakage but would be channeled into additional investment, and called this “the Kalecki effect”.

Second, Ricardian equivalence was invoked, tentatively put forward by David Ricardo in the early 19th century and re-discovered by Robert J. Barro in 1974. When government expenditure is raised, funded by borrowing, economic agents discount the future payments of higher taxes that they anticipate having to pay to service the higher debt. The effect is the same as it would be if expenditure was funded directly by an immediate higher tax: lower private consumption offsetting higher government expenditure. (The reader is invited to perform a mental experiment: is this how he/she responds to a fiscal stimulus by the government? I certainly don't).

Third, in the early ‘seventies the theory of so-called rational expectations was introduced by Robert Lucas and others, which was a tendentious misnomer. They should have been called expectations successful by definition. The efficient utilization of all information available, by all economic agents, makes markets efficient. Nobody is ever surprised. Multipliers could then be lower than unity.

Fourth, in the 1990s and 2000s a series of empirical studies propounded the idea of “Expansionary Fiscal Contraction”. They argued that closing the budget deficit via higher taxes and/or lower expenditure can be and by and large is expansionary: see Giavazzi and Pagano (1990, 1996); Alesina and Perotti (1997); Alesina and Ardagna (2010). Blanchard (1990, then Professor at MIT, before joining the IMF as Chief Economist in 2008) explained how this was due to the promotion of private sector-led growth, for the reasons already mentioned above: Ricardian equivalence, increasing confidence, a favourable impact on expectations, declining borrowing costs, a weaker currency. This would hold also for "extreme" fiscal contraction or consolidation.

Growth in a Time of Debt

But the culmination of the expansionary fiscal consolidation thesis, supported by the so-called "austerians"' - "advocates of fiscal austerity, of immediate sharp cuts in government spending" (Krugman's definition) - is a paper by Harvard economists Carmen Reinhart and Kenneth Rogoff, "Growth in a Time of Debt" (2010). On the basis of a new dataset of forty-four countries spanning about two hundred years, incorporating “over 3,700 annual observations covering a wide range of political systems, institutions, exchange rate arrangements, and historic circumstances”, Reinhart and Rogoff find that “the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more.” 

The notion that government debt exceeding 90 percent of GDP has a significant negative effect on economic growth became a decisive supportive argument for austerity by national and international leaders, from ex-vice-presidential candidate Paul Ryan, chairman of the USA Congress budget committee, to EC Commissioner Olli Rehn, and authoritative commentators. Thus Keynes's proposition that “the boom, not the slump, is the right time for austerity” was falsified, austerity becoming a good policy for all seasons in highly indebted countries.

The tide is turning

The proposition of "Expansionary Fiscal Consolidation" was immediately subjected to many criticisms and was gradually discredited both on theoretical and on empirical grounds.

Already in November 2008 the IMF Managing Director Dominique Strauss-Kahn took the initiative for a sizeable global fiscal stimulus of the order of 2% of Global GDP. In an interview with IMF Survey Online on 29 December 2008 Olivier Blanchard – by then IMF Chief Economist, and Carlo Cottarelli, Chief of the IMF Fiscal Affairs Department, called for bank recapitalization (time consuming) and monetary expansion (ineffective at low interest rates) and made a strong case for fiscal stimulus: "In normal times, the Fund would indeed be recommending to many countries that they reduce their budget deficit and their public debt. But these are not normal times, and the balance of risks today is very different"… "If no fiscal stimulus is implemented, then demand may continue to fall. And with it, we may see some of the vicious cycles we have seen in the past: deflation and liquidity traps, expectations becoming more and more pessimistic and, as a result, a deeper and deeper recession. If, instead, a fiscal stimulus is implemented but proves unnecessary, the risk is that the economy recovers too fast. Surely, this risk is easier to control than the risk of an ever deepening recession." The IMF raised its lending, increased its own resources and relaxed somewhat its conditionality, but its commitment was intermittent and short lived. The ECB, under the leadership of Jean-Claude Trichet, soon was advocating an early exit strategy from both monetary expansion and fiscal stimulus.

In October 2010, Chapter 3 of the IMF World Economic Outlook examined “the effects of fiscal consolidation — tax hikes and government spending cuts—on economic activity.” It found that fiscal consolidation typically reduces output and raises unemployment in the short term, especially if it occurs simultaneously across many countries, and if monetary policy is not in a position to offset them. Only in the longer term, can interest rate cuts, a fall in the value of the currency, and a rise in net exports usually “soften” but do not offset the contractionary impact.

Baker (2010) criticises Alesina and others (1995, 2006) for their use of cyclically adjusted deficits, while policy driven deficit adjustments behave in a keynesian fashion. He also criticises Broadbent and Daly (2010) on the ground that known cases of expansionary consolidation occurred for very narrow output gaps relatively to the large ones that occur in the current crisis.

The September 2011 IMF Fiscal Monitor warned that “too rapid consolidation during 2012 could exacerbate downside risks”: “Further tightening during a downturn could exacerbate rather than alleviate market tensions through its negative impact on growth”.

In 2012 Carlo Cottarelli stressed the “schizophrenic” attitude of investors with regard to fiscal consolidation manoeuvres: their initial enthusiasm is followed by the fear of consequent recession, so that governments are “damned if they do, damned if they don’t”.

The IMF World Economic Outlook (October 2012) contains a large Box by its Chief Economist Olivier Blanchard and Daniel Leigh arguing that fiscal multipliers have been under-estimated by IMF forecasts and policy documents, by the OECD and the European Commission. Recent IMF research suggests that fiscal multipliers are in the range 0.9 to 1.7, rather than the customary assumption of their being around 0.5. In other words, the cost of fiscal consolidation has been grossly under-estimated. In January 2013 Blanchard and Leigh presented a longer paper expanding their argument at the American Economic Association Annual Conference. However, according to the auhors “More research is needed.”

But more research was already available to the IMF: Guajardo, Leigh and Pescatori (2011) investigated "the short-term effects of fiscal consolidation on economic activity in OECD economies." "We examine the historical record, including Budget Speeches and IMF documents, to identify changes in fiscal policy motivated by a desire to reduce the budget deficit and not by responding to prospective economic conditions. Using this new dataset, our estimates suggest fiscal consolidation has contractionary effects on private domestic demand and GDP. By contrast, estimates based on conventional measures of the fiscal policy stance used in the literature support the expansionary fiscal contractions hypothesis but appear to be biased toward overstating expansionary effects.”

And Batini-Callegari-Melina (2012)
-  discredit the need for cutting public/social expenditure, for especially in a downturn expenditure multipliers can be up to ten times larger than tax multipliers;
- find absolute values for multipliers of the order of 2.5 instead of 0.9-1.7 as in the IMF World Economic Outlook (2012);
- find aggressive consolidation much more expensive than gradual in terms of GDP.

In May 2013 Jeffrey Frankel criticized various papers by Alesina and other co-authors (Giavazzi, Ardagna and Favero), all claiming that fiscal consolidation is not contractionary in a recession. Frankel’s objections are based on a recent paper by Alesina's original coauthor, Perotti, criticizing the dating methodology used, and pointing out that some of the fiscal consolidations used by Alesina et al. were announced by governments but never implemented. Thus Frankel concludes that Alesina "has not been receiving his fair share of abuse” (Eurointelligence.com, 22/5/2013).

At the same time Alesina and Giavazzi softened very considerably their original position. In May 2013 they actually recommended the Italian government to overstep the 3% deficit threshold for two years – for “that three per cent should not be a taboo” – offering the EC in exchange  immediate tax reductions on labour incomes and planned gradual and permanent expenditure cuts in the following three years. The European Commission would not close the excess deficit procedure for Italy at end-May but should be willing to approve such plan and verify its implementation. At the same time, credit to households and enterprises should resume through bank re-capitalisation conditionally funded by the EMS.

The non-existent 90% threshold

The Reinhert-Rogoff notion of a critical 90% threshold of the debt/GDP ratio was immediately criticized by Irons and Bivens (2010) who argued that causation run backwards, in that slower growth leads to higher debt-to-GDP ratios rather than the other way round. Moreover “there is no compelling reason to believe … that gross debt of about 90% will necessarily lead to slower economic growth… In fact, the greatest threat to economic growth is policy inaction fueled by deficit fears.”

The final blow to the Reinhart-Rogoff 90% debt/GDP dogma came from Herndon, Ash and Pollin (2013), who replicated the analysis by Reinhart and Rogoff 2010 using the original data. Apart from a coding error, which
made only a small contribution to their conclusions, Reinhart-Rogoff selectively excluded available data for several Allied nations—Canada, New Zealand, and Australia—that emerged from World War II with high debt but nonetheless exhibited solid growth. And summary statistics were all weighted equally regardless of the duration of high debt and growth performance. Herndon et al. (2013) conclude that “… when properly calculated, the average real GDP growth rate for countries carrying a public-debt-to-GDP ratio of over 90 percent is actually 2.2 percent, not 0.1 percent as published in Reinhart and Rogoff”. It turns out that “average GDP growth at public debt/GDP ratios over 90 percent is not dramatically different than when debt/GDP ratios are lower.”

Reinhart and Rogoff (2013) admitted some of their errors and
omissions but argued that these do not alter their ultimate austerity-justifying conclusion: excessive debt depresses growth. But two subsequent studies have claimed that, on the contrary, slow growth appears to cause higher debt (as Irons and Bivens 2010 had already argued). Dube (2013) finds that growth tends to be slower in the five years before countries have high debt levels. In the five years after they have high debt levels, there is no noticeable difference in growth at all, certainly not at the 90 percent debt-to-GDP level regarded by Reinhart and Rogoff as the threshold of non-sustainability. Kimball and Wang (2013) present similar findings. This point is accepted by Reinhart-Rogoff (2013): "The frontier question for research is the issue of causality."

But suicidal policies persist

Such an amazing, cumulative and final discrediting of the alleged expansionary (severe at that) fiscal contraction approach, and the associated 90% threshold to debt sustainability, does not appear to have had much impact on actual policies, especially on German-led European policies, with EU and especially EMU countries tied to the "suicide pact" (Joseph Stiglitz) of so-called Growth and Stability.

The latest EU Fiscal Compact or TSCG – Treaty on Stability, Coordination and Governance – demanded a balanced budget provision to be inserted in member states’ national constitutions, subject to a maximum structural deficit of 0.5% of GDP. There are penalties and automatic adjustments in case of inobservance, subject to the verification and rulings of the European Court of Justice. Financial assistance programmes under the ESM – the European Stability Mechanism that come into operation in March 2012 – from March 2013 are conditional on prior TSGC ratification.

From 2015 countries exceeding the statutory debt/GDP ceiling of 60%, required by both the Maastricht Treaty and the Stability and Growth Pact, are expected to reduce the excess debt by 1/20 of the current gap every year until the ceiling is reached – which for a country like Italy at over 130% involves a budgetary surplus of over 3.5% a year for 20 years.

The IMF (2013) Report criticized the Troika’s [EC, ECB, IMF] handling of the Greek crisis over the last four years, but concluded that all was for the best and their policies would not be any different today in the same circumstances. In July 2013 a conference of German economists advocated that a debt/GDP ratio of 90% - Reinhart and Rogoff’s fated but dubious threshold – should trigger off automatic debt re-structuring and bail-in.

Austerity is like compulsory smoking

In conclusion, the Keynesian-Kaleckian view of capitalist dynamics is alive and well. The IMF itself has been reviving it and providing theoretical and empirical backing for it, by stressing the high cost of fiscal consolidation, but at the same time continuing to officially recommend and impose such fiscal consolidation. While providing the strongest case for a fiscal stimulus, IMF research is being used even by their more enlightened officials to recommend gradual rather than abrupt fiscal consolidation, instead of the fiscal stimulus that would be appropriately needed. Obstacles to full employment policies are still of a political nature today (resistance to a capital tax to service exceptionally high sovereign debt, in addition to the drive to maintain workers’ discipline through unemployment). The time for a Kaleckian (and Keynesian) over-due revival is now, but until it takes place we are all condemned to suffer from the impoverishment and the unemployment caused by the deepest, man-made, economic crisis in human history.


Alesina, A. and R. Perotti (1995). “Fiscal Expansion and Adjustments in OECD Economies”, Economic Policy, 207-247.
Alesina, A., S. Ardagna, and F. Trebbi (2006), “Who Adjusts and When? The Political Economy of Reform”, IMF Staff Papers, V. 53 Special Issue, Washington.
Alesina Alberto and Francesco Giavazzi, (2013), “Crescita, una proposta alternativa: Quel tre per cento non sia un tabù”, Corriere della Sera, 17 May.
Baker Dean (2010), “The Myth of Expansionary Fiscal Austerity”, CEPR, October.
Barro Robert J. (1974), “Are government bonds net wealth?”, Journal of Political Economy 82(6), pp. 1095-1117.
Batini Nicoletta, Giovanni Callegari and Giovanni Melina (2012), “Successful Austerity in the United States, Europe and Japan”, IMF Working Paper 12/190, July, Washington.
Blanchard Olivier J. (1990), “Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries: A Comment”, NBER Macroeconomics Annual Vol. 5, (1990), pp. 111-116, MIT Press, Cambridge, Mass.

Broadbent, B. and K. Daly (2010), “Limiting the Fall-Out from Fiscal Adjustments”, Goldman Sachs Global Economics Paper 195.
Cottarelli Carlo (2012), “Fiscal Adjustment: Too Much of a Good Thing?”, Posted on January 29 by iMFdirect.
Dube Arindrajit (2013), “A Note on Debt, Growth and Causality”, Draft forthcoming, May 30.
Giavazzi Francesco and Marco Pagano (1990), “Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries”, NBER Macroeconomics Annual Vol. 5, (1990), MIT Press. Cambridge Mass.
Giavazzi Francesco and Marco Pagano (1996) "Non-Keynesian Effects of Fiscal Policy Changes: International Evidence and the Swedish Experience," NBER Working Papers 5332, National Bureau of Economic Research, Inc.
Guajardo Jaime, Daniel Leigh and Andrea Pescatori (2011), "Expansionary Austerity: New International Evidence", IMF WP/11/158, Washington. don Thomas, Michael Ash and Robert Pollin (2013), “Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff,” Political Economy Research Institute, Working paper n. 322, April 15, Amherst.
Irons John and Josh Bivens (2010), “Government Debt and Economic Growth: Overreaching Claims of Debt “Threshold” Suffer from Theoretical and Empirical Flaws”, Economic Policy Institute, 26 July, Briefing Paper #271.
International Monetary Fund (2010), “Will It Hurt? Macroeconomic Effects of Fiscal Consolidation.” World Economic Outlook, Chapter 3, Washington.
International Monetary Fund (2013), “Greece: Ex Post Evaluation of Exceptional Access Under the 2010 Stand-By Arrangement,” June, Washington.
Kalecki Michal, (1933) Proba teorii koniunktury [An Essay on the Theory of Business Cycle], Instytut Koniunktury I Cen, Warsaw. As “Outline of a theory of the of Business Cycle”, in Kalecki, 1971.
Kalecki Michal (1934), “On foreign trade and ‘Domestic Exports’”, translated from Polish in Kalecki (1971).
Kalecki Michal (1935), “A macrodynamic theory of business cycles”, Econometrica 3, July, pp. 327-44.
Kalecki Michal (1943), “Political aspects of full employment”, The Political Quarterly, p. 332-331.
Kalecki Michal (1971), Selected essays on the dynamics of the capitalist economy 1933-1970, CUP, Cambridge.
Keynes J. Maynard (1936), The General Theory of Employment, Interest and Money, London, Macmillan.
Kimball Miles and Yichuan Wang (2013), “After crunching Reinhart and Rogoff’s data, we’ve concluded that high debt does not slow growth”, QUARTZ, 29 May.
Olivier Blanchard and Daniel Leigh, “Growth Forecast Errors and Fiscal Multipliers,” IMF Working Paper, January 2013.
Lucas Robert (1976), "Econometric policy evaluation: A critique", Carnegie-Rochester Conference Series on Public Policy 1 (1), pp. 19–46.
Nuti Domenico M. (2004), “Kalecki and Keynes Re-visited”, in Zdzislaw L. Sadowski and Adam Szeworski (Eds), Kalecki’s Economics Today, Routledge, London and New York.
Reinhart, Carmen M. and Kenneth S. Rogoff (2010), "Growth in a Time of Debt", NBER Working Paper No. 15639, January.
Reinhart, Carmen M. and Kenneth S. Rogoff (2013), “Responding to Our Critics”, The New York Times, 25 April.
Robinson Joan V. (1976), “Michael Kalecki: a neglected prophet”, New York Review of Books, 23, 4 March, pp. 28-30.


In my answer to Branko (see Comments to this post) I wrote:

"If the size of the fiscal multiplier (which is the weighted average of the multipliers applicable to various expenditure cuts and tax rises involved) is greater than the current debt/GDP ratio, as the latest IMF researchers suggest, then fiscal consolidation raises such a ratio."

I should have written:

"If the size of the fiscal multiplier (which is the weighted average of the multipliers applicable to various expenditure cuts and tax rises involved) is greater than the inverse of the current debt/GDP ratio, as the latest IMF researchers suggest, then fiscal consolidation raises such a ratio."  


Anonymous said...

A parte l'inizio, che un fumatore irrimediabile come me non può apprezzare, tutto il resto non si può non condividere. Anzi si può, come purtroppo vediamo: ma sono da tempo convinto che il motivo non è teorico, ma squisitamente politico. L'ha riassunto bene Warren Buffet con la sua famosa frase: "la lotta di classe esiste, e l'ha vinta la mia classe". (Carlo Clericetti)

Anonymous said...

Caro dott. Clericetti,
La lotta di classe inizia quando arriva Ugo (la fame).
Il prof. Nuti conferma ogni volta di essere su un piano più alto rispetto al mainstream (@rbsnt)

Frank said...

At least in Italy industrial leaders seem to oppose austerity. Are they more enlightened than usual or are they feeling the bite?

D. Mario Nuti said...

Of course they are beginning to feel the bite. Pity Berlusconi is all mouth and no trousers.

D. Mario Nuti said...

A friend sent me a chilling comment via e-mail: "I greatly fear that killing is part of the idea."

Alberto Chilosi said...

The problem with Keynes's proposition that “the boom, not the slump, is the right time for austerity” is that in the boom there is no hard budget constraint pushing towards “austerity” because optimism, and “irrational exuberance” make the financing of public deficits and private debts alike all too easy. Moreover in a number of countries (especially the “Mediterranean” ones) politicians like to spend more rather than less, in order to build consensus under any circumstances (but especially if elections are around the corner). Later on the service of the debt will limit the extent to which public revenues could be used for substantial purposes, but this is a problem for future politicians to tackle. The main corrective to this kind of behaviour may be an independent central bank having technical expertise and taking the longer run into consideration. But economics is not an exact science and central banks, independent or otherwise, may be prone to tragic mistakes (as it was apparently the case with the Fed under Greenspan). In the recession, when pessimism and propensity against risk do prevail, countries that were running excessive debts during boom may be considered by the market excessive risks and have difficulty to further finance their deficits at sustainable conditions. A national central bank may finance the deficit instead of the market through money creation, but this does not apply to the current account deficit (at least unless the country has an international reserve currency, but even this has its limits). Even if Greece had kept the drachma the persistent financing of a current account deficit of the order of 10% of GDP would have been impossible, and the end of it would have thrown the country in deep recession, while monetary financing of the deficit in the boom would have caused arguably very high inflation. But perhaps with the drachma nobody would have been willing to finance such a high current deficit for a sustained period, in the first place.

D. Mario Nuti said...

No incentive to introduce austerity in a boom, you say. But there is austerity and austerity, Alberto. If Italy was not tied down by European Treaties, it could contain austerity and indeed afford a substantial additional stimulus without raising borrowing costs to unsustainable levels.

And if Greece had had the Drachma it would have been constrained by both availability and cost of international finance in its ability to fund deficits, as you say. But also it would have been able to devalue to promote net exports to alleviate the crisis.

Michael Ellman said...

I naturally agreed with your critique of much of what passes as macroeconomics these
days. However, I doubt whether doctrines have as much influence as you imply (although they may be quoted by officials and politicians, the latest macroeconomic papers do not determine policy, which has other origins).

In particular, I think you miss the source(s) of German economic policies, which are not based on the latest international economics literature, but on structural factors:
(1) Germany has a successful export sector and relies for growth on world demand for its manufactures. It (normally) does not use domestic fiscal policy for this purpose and does not need to.
(2) To support the export sector Germany has appropriate training, banking and technical progress policies and institutions. It relies heavily on these sensible supply side policies.
(3) For demand side stimulation it uses wages policy to increase the competitiveness of its exports.
(4) It is exceptionally difficult to sell to the electorate in a democratic political system the idea that Germany should provide large sums in fiscal transfers to other countries which are perceived in Germany “to be behaving badly”. Hence the difficulties of
‘banking union’. When monetary union was introduced, Germans – who were giving up their beloved DM – were told that there would be no fiscal transfers (which was written into the Maastricht Treaty).

What may change the mind of German leaders is stagnation or worse in Germany resulting from recessions/depressions in other EMU countries and the rest of the world. From this point of view the slowdown in China is beneficial – it will have a negative effect on German exports and growth. This will make Germany more sympathetic to efforts to revive its European export markets.

(to be continued)

Michael Ellman said...


I think those officials and economists who argue for ‘structural reforms’ to complement activist fiscal policy have some sensible arguments. For example, here in the Netherlands, which has a very large current account surplus and is in a recession with rising unemployment, the government is planning further ‘fiscal consolidation’ (tax increases & expenditure cuts) to get the budget deficit below 3%. This strikes me as stupid for obvious reasons (even the employers’ organisations have come out against).

However some structural reforms which are being discussed/proposed/implemented are quite sensible.

(1) Mortgages. We had until very recently a system under which all the interest on a 30 year mortgage was tax-deductible over its whole length at the taxpayer’s highest marginal rate of income tax. As a result almost everybody who took out a mortgage only repaid at the end of the 30 years, depriving the government of a very large and rising amount of tax and also destabilising the banking system (which is now facing falling collateral values and rising defaults). This system is being slowly changed, a policy supported – quite rightly – by the EU.

(2) The laws governing dismissals and the social security system make taking on workers both risky and expensive. Although I do not agree with much that is proposed in this area, no doubt some changes would be sensible.

(3) The banking system is in a poor state and whatever the government does on the fiscal front the weak state of the banking system will hinder growth.

(4) Stimulation of technical progress. The government has put in place a number of measures to stimulate technical progress (tax concessions for R & D, cooperation between business & universities, direct financial support in certain key sectors, etc). This benefits hi-tech firms, of which we have quite a few.

It is necessary to recognise that ‘structural reforms’ can be useful before castigating countries for not accepting the ideas of Keynes (which partly reflected the specific situation in the British Empire in the 1930s). Countries are different and one size does not fit all, whether it is Keynesian or ultra liberal. As for Kalecki, ‘fiscal consolidation’ here is not being supported by the employers (who can see its effects on their profits), but by the fact that we are a small foreign-trade dependent economy where the conjunctural situation is traditionally determined by the world market. A specific cause is that the leading politicians feel they have to adhere to the 3% rule (they made a trap for themselves by telling the “sinners” how important this was). Both Germany and the Netherlands follow Kaldor’s advice – allow exports to determine your growth and pursue policies which stimulate them.

Michael Ellman

Alberto Chilosi said...

In considering the issue of austerity vs. fiscal stimulation in the Eurozone no mention has been made of the essential point that in the USA the fiscal policy is the domain of the Federal budget. No assistance to the budgetary problems of the states is provided, to my knowledge, by the Federal Reserve. States and local authorities have a strict budget constraint and can even fail, in principle. This is because of obvious moral hazard reasons: what would it happen if the states and the local authorities had the guarantee to be financed by the Federal Reserve whatever their deficits?
The same moral hazard reasons in the EU lead to the prohibition of the monetary financing of the states, as inscribed in the Maastricht Treaty. But in the EU we do not have a real Federal Budget and even if we had the cumbersome budgetary rules of the EU would apply anyhow, making anticyclical fiscal policy rather difficult to pursue. The provision has been somehow overcome under the pressure of the crisis, the moral hazard issue having been tackled by strict conditionality, aiming at avoiding Ponzi games. Another way could have been to overcome the problem by devising the possibility by the BCE to finance monetary and fiscal expansion at the Eurozone level (as does the Federal Reserve at the Federal level) together with some objective rule avoiding the moral hazard issue: for instance through non sterilized purchases of state bonds in the same proportion as the share of the states in the capital of the bank. One should not forget that before becoming a fiscal crisis the crisis originated with a recessionary monetary shock and a credit crunch. Here is where the BCE may have failed: by not engineering an adequate process of compensatory monetary and credit expansion at the Eurozone level. A possible obstacle being however that we were in a recession, but without deflation, in the sense that the price level has continued to increase, albeit at a different rate in the different countries (not necessary the countries most affected by the crisis showing a lower rate of inflation). Unlike the world of Keynes and Kalecki unfortunately we can have not only stagnation and inflation, but both of them at the same time.

D. Mario Nuti said...

Thanks, Michael. Clearly we have a fair amount of Cambridge DNA in common.

Doctrines may not be really influential on policies, but Treaties obligations have teeth. I always sympathized with German objections to finance highly indebted member countries with the issue of Eurobonds (European bonds carrying joint and several liability of members), which Germany would have ended-up paying (although no less than Vito Tanzi recently reported that, at the time of Italy’s unification in 1862, the Italian government’s pooling of its regional states’ debt was beneficial all round).

But I do not see why, for instance, the Germans should prevent the ECB from using its seigniorage to buy government bonds of member states in the same proportion of their ECB shareholdings.

Germany’s successful export performance is part of the problem: they get away with a trade surplus of 6% of GDP with EC blessing, when they could reflate costlessly to the benefit of the whole Euro-Area instead of making life all that harder for the Southern members.

Structural reforms cover a multitude of sins, and mean different things to different governments. Some are more necessary than other, some are dubious, but they will all act slowly and gradually. Fiscal consolidation is necessary to signal a country's determination to pay but, if fiscal multipliers are higher than a country's current debt/GDP ratio, fiscal consolidation will raise debt relatively to GDP, making things worse. Rating agencies looking at such ratio will downgrade the consolidating countries and therefore raise the cost and sustainability of their debt.

D. Mario Nuti said...

Good points, Alberto. The EU budget is under 2% of EU GDP, and it is always balanced ex-post by a levy on member states’ income. Therefore it can never guarantee a primary surplus out of which it could service debt incurred by Europe as a whole. The US has enough of a budget to borrow on behalf of the Federal State – although it is also subject to a debt ceiling that forces it to undertake automatic retrenchment (the current “sequestration” charade) unless it is lifted by Congress every time.

But – as you point out – the US have a central bank that can and does buy government bonds, which the ECB cannot do without meeting all kind of conditions and quantitative limits.

And yes, Jean-Claude Trichet has his share of responsibility - recession or no recession he advocated an exit strategy too soon. Mario Draghi has done more than the Germans would have liked – fortunately - with great courage and imagination.

Branko said...

My impression is that Spain, Portugal and perhaps Italy went for austerity policies not willingly but rather because the costs of incurring fresh debt were too high. In other words, one could keep on borrowing, but borrowing at 5-6-7% was thought too onerous.

Now the question is: let's suppose that there is such a point X at which interest rate is prohibitively high (say, there are no government or otherwise projects that could generate such a return).

How can government then not follow the austerity policy (assuming, of course, that they do stay with the euro)?

D. Mario Nuti said...

Your question is very important, Branko.

Fiscal consolidation is a very ambiguous signal. On the positive side, it signals a country’s renewed determination to pay off its debt, by reducing its absolute amount. On the negative side, if the size of the fiscal multiplier (which is the weighted average of the multipliers applicable to various expenditure cuts and tax rises involved) is greater than the current debt/GDP ratio, as the latest IMF researchers suggest, then fiscal consolidation raises such a ratio. This rise is one of the more important factors affecting the cost of borrowing, by making repayment objectively more problematic, also in the judgement of rating agencies.

The net impact of these effects is uncertain: I quoted the IMF official in charge of Fiscal Affairs, Carlo Cottarelli, who speaks of investors’ schizophrenia: their initial enthusiasm for fiscal consolidation is often followed by concerns about the income decline being proportionally greater than debt decline. Paradoxically fiscal consolidation may turn out to be less instead of more sustainable than fiscal stimulus.

Otherwise you are of course correct: at some point a prohibitive borrowing cost forces a country to consolidate no matter what - but international obligations to observe various fiscal parameters are likely to become operational constraints before your point X is reached.

Kazimierz Laski said...

I would like to add that deficit spending is the rule rather than the exception, even in Germany. In Kalecki’s world the mark-up determines the profit share in GDP and - in a simplified model - private investment (IP) minus private household savings (SH) determine profits and via profits also GDP. Normally the difference (IP -PS) stays below profit (and hence GDP) at full - or even high - employment level. Disregarding net exports, deficit spending is thus the most important venue to achieve a higher level of employment and aggregate production than without a deficit. If this is the case normally - or most of the time - a balanced budget rule is dangerous even without a crisis, and a true calamity in conditions of falling incomes, or even stagnation or slow growth.

However, the current account deficit may be - and in many cases is - a decisive factor limiting the possibility of properly using deficit spending as an instrument of employment policy.

Of course we must note that over the last decades profit tax rates have become much lower than before. The possibility of covering part of Government spending by means of profit taxation is a topic almost completely forgotten now, that deserves re-consideration.

D. Mario Nuti said...

Thanks for some very good points.

Or course Kalecki (1943) envisaged covering interest on large scale public debt out of a capital tax, which in realised capitalism is anathema today.

Ciro said...

The problem seems to be not only high government debt but the accumulation of government unpaid bills for goods and services provided by private enterprises.

D. Mario Nuti said...

Yes, Ciro. When deficit and debt are recorded on a cash basis, instead of doing it on accrual, there is an incentive for governments to respect the constraints on both by postponing payment. Especially in a recession this starves enterprises of cash and contributes to exacerbate the downturn.

In Italy we do not even know exactly how much the government owes to private enterprises, probably about €80 bn, possibly much more.

Households are also owed money, for instance 390,000pensioners who took early retirement just before the retirement age was raised by Ms Fornero, being left without a job nor a pension (the so-called "esodati").

This is illegal, indecent behaviour on the part of the government. Borrowing incurred to clear such arrears should not be counted as an ibcrease of government debt.

Don said...

Italy has a large public sector debt of the order of 130% of GDP, but is reputed to have a particularly low private sector debt. Whatever the merits of the case for austerity, can a lower private debt somehow facilitate the management of public debt?

D. Mario Nuti said...

Before Italy joined the Euro in 1998 private sector debt was about 80% of GDP, while public debt was around 120% of GDP. Since then public debt has grown little remaining just above the same level at the end of 2012 (reaching about 130% at the end of 2013), while private sector debt has escalated to 260% of GDP by end 2012. During the period in question therefore joint private and public debt has practically doubled to just over 400% of Italian GDP.

It is true that Italian households have very substantial real and financial assets of the order of 4 times the country’s GDP, but political opposition to tap these resources through capital taxation for debt service makes their existence completely irrelevant for the purpose of debt management.

Peter Mihaly said...

From Mario's illuminating and abundantly documented paper four interrelated points are missing:

(i) the underlying trend of growth in the given country; (ii) the cost of borrowing (iii)the possibility of external default on public debt and (iv) the size and the dynamics of private debt.

Hungary is a tragic illustration of the dilemmas arising from the above mentioned four constraints. It seems that the structural problems of the Hungarian economy brought down the trend growth to 1-2 per cent at a time, when the cost of borrowing is in the range of 4-8 per cent. Moreover, the vulnerability of Hungary's external position stems from the exponential rise of private debts (corporations and households). As a share of GDP public debt was not growing dramatically prior to 2008.

Jorge Garcia Arias said...

Dear Mario, perhaps this article in the British Medical Journal may be of interest to you.

"Will austerity cuts dismantle the Spanish healthcare system?"

BMJ 2013; 346 doi: http://dx.doi.org/10.1136/bmj.f2363 (Published 13 June 2013)
Cite this as: BMJ 2013;346:f2363

D. Mario Nuti said...

Many thanks, Jorge. Spot on, and very frightening. And thanks for the link, the paper can be accessed free of charge on a 14 days trial subscription.

D. Mario Nuti said...

Mihályi Péter makes very good point. An economy growing at a rate lower thab the interest rate at which it borrows is on an unsustainable path - though default may be a long way away especially if it is willing to dip into its citizen pockets to pay for the interest.

A small private sector debt is no use, unless there is political willingness to tax private net assets, whereas large scale private sector debt - as in Hungary - is a serious vulnerability factor.

D. Mario Nuti said...

Mihályi Péter has written on the consequences of spending cuts for healthcare in Hungary:


Remo said...

You may have underestimated government payment arrears owed to Italian private enterprises. The Bank of Italy latest estimate is €91bn.

Jerzy said...

I thought the worse economic crisis ever was that accompanying the transition from socialist central planning to capitalist market economies in the ex-USSE and Central Eastern Europe.

D. Mario Nuti said...

So it was, the transition process of the 1990s was accompanied by a deep and often protracted ‘transformation recession’ (Kornai’s label).

Poland experienced the shortest and smallest fall in income (17% of 1989 GDP in just under three years) recovering its 1989 level in 1996 and moving rapidly ahead, while Georgia had the largest and most prolonged fall (75% by 1994 before reversing, and still below the 1989 level in 2011) – leaving aside the transition countries that experienced war (with Bosnia and Herzegovina at over 80% GDP decline and by 2012 still not fully recovered).

However, it was a regional recession, limited to the ex-USSR and Central-Eastern Europe. I was referring to global recessions.

However austerity - under the guise of so-called "shock therapy" - had much to do also with the transition recession, as transition economies moved from supply side constraints to lack of effective demand.

Often there were inordinately high interest rates up to usury levels; fiscal policy restrictions that constrained the deficit in cash terms, leading to de-monetisation and the building of arrears in government payment to enterprises and among enterprises; accidental, unintended budgetary surpluses; enormously costly sterilization of capital inflows; draconian wage controls and punitive taxation of wage rises above a very feeble rate of indexation; the dismantling of the welfare state; and so on.

The transformation recession was not, or should not have been, a surprise, but a mathematical certainty, although only a Kaleckian economist such as Kazimierz Laski (in Wirtschaftpolitische Blatter n.5,1990) was able to anticipate it, forecasting correctly a range of 15-20% GDP fall in Poland.