Working on a book chapter on figuring out how to turn fiscal policy right-side up again, riffing off of my CDSH hobby horse:
Me, I think the best position is to be a Cyclical Dove and a Structural Hawk (CDSH). If you’re a CDSH, your fiscal question in recessions and sloggy periods like the US (and much of Europe) are experiencing today is this: “is our budget deficit large enough to offset the demand contraction from the private sector?”
When strong private sector growth is back, the CDSH asks “now that we’re back to robust growth, are our revenues and spending lined up such that the debt we built up during the down economy will soon start to recede?” That is, deficits and debt that grow in full employment economies are called “structural” budget deficits as distinct from cyclical ones. They’re to be avoided.
In this regard, the Eurozone has ultimately reacted to the downturn as a Cyclical Hawk—i.e., in austerity mode, and that’s been a big problem. The figure below plots real GDP growth and government spending, both indexed to ‘1’ and unemployment on the right-hand axis.
Government spending initially stepped up to offset the sharp contraction of private sector demand, as GDP began to grow and unemployment stabilized. Then, as various governments in the Eurozone prematurely began to consolidate their budget deficits, government spending flattened, unemployment took off again, and GDP reversed course.
Obviously, data like these collapse a lot of moving parts into one trend line, and different countries face different pressures. There are cases in southern Eurozone countries where the loss of fiscal credibility is quite clearly linked to very high borrowing costs. Regarding Italy, for example, Corsetti notes: “The current fiscal tightening is arguably contractionary, but the alternative of not reacting to the credibility loss would have produced much worse consequences.”
Still, that doesn’t explain the adoption of deficit reduction in the UK, nor, for that matter, the US. And while in this country we’re on track to stabilize the debt-to-GDP ratio, at least until the pressure of health costs leads the ratio to start growing again, there are Eurozone countries for whom austerity has been self-defeating even from a fiscal perspective. Greece, Italy, and Spain, for example, remain stuck in the vise of some highly unforgiving arithmetic, where the interest rate on their debt is higher than their GDPs nominal growth rate. That’s a recipe for more public debt, even higher interest rates, and so on.