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Fiscal Discipline and All That

Rarely has an economic idea had such a brief revival.  After several years of almost undisputed sway of monetarist ideology over economic policy makers across the world, suddenly Keynesian ideas were back in fashion, in particular the idea that active state intervention in the form of increased state expenditure is necessary to bring a market economy out of a recession or depression.

When the global financial crisis broke in September 2008, leading to what is now called “The Great Recession,” suddenly policy makers everywhere turned to Keynesian ideas to rescue the world economy.  Not only were governments — especially in the developed capitalist countries — required to spend or provide for huge amounts of money to bail out companies in trouble, but they were actually encouraged to spend much more to provide fiscal stimuli to prevent recession.

This enthusiasm for strong fiscal intervention in the face of crisis even infected the hoary old supporter of fiscal rectitude, the IMF.  In its annual flagship World Economic Outlook which appeared in the midst of the outbreak of the crisis in September 2008, the Fund argued that

Macroeconomic policies in the advanced economies should aim at supporting activity, thus helping to break the negative feedback loop between real and financial conditions, while not losing sight of inflation risks. . . .  Discretionary fiscal stimulus can provide support to growth in the event that downside risks materialize, provided the stimulus is delivered in a timely manner, is well targeted, and does not undermine fiscal sustainability.  (Page 34)

The G20 group of countries that set themselves up as the power lobby to run the world also declared their support for collective fiscal expansion in their early post-crisis meetings.  Even bankers and large multinational company executives hailed this shift as necessary, even critical, to save global capitalism.

And then suddenly, and so quickly as to be quite unexpected, it was over.  The brief honeymoon that financial markets had with state intervention appeared to sour as soon as the banks felt strong enough (as a result of the massive bailouts they had been given and the very low interest rates that were applied everywhere) to manage without any more direct funds.  And they — along with other financial players — turned on the source of their deliverance, increased government spending.

The attacks began first in the financial press, with fears being expressed about rapidly rising government deficits and fears about the sustainability of government debt levels.  They then spread quickly to bond markets themselves, which attacked any government that was perceived as having a slightly weaker position in terms of aggregate debt levels.

A more classic case of biting the hand that has fed you would be hard to find.  It turns out that of the top ten countries whose governments saw a significant deterioration in their fiscal balances in 2008, a majority had actually been running fiscal surpluses just the year before.  And for the largest of such countries — the US and Spain — the change in fiscal situation was directly related to the large bank bailouts that had to be provided.  Indeed, Spain, Mongolia, Iceland, Latvia, and Turkey had all been running fiscal surpluses in 2007.  It was private sector irresponsibility that created the imbalance and associated crisis in all of these countries, but it was the government that had to step in and save the economy as well as its most reckless banks.

What they have now got for their pains is a prolonged hammering from bond markets, which are demanding massive cuts in public expenditure that would require enormous sacrifices from their populations.  So the banks are putting pressure on governments to reduce government deficits that their own actions necessitated, but in ways that preserve their own incomes and profits while imposing austerity on workers and other hapless citizens.

All this is particularly surprising because there is no theoretical or empirical basis for deciding that a particular level of public debt is more than what is acceptable, or that a particular debt trajectory is sustainable, or even that a particular level of fiscal deficit will generate so much more debt over time.  All of these depend upon several other factors, none of which is likely to stay the same.  So, most predictions of future public debt levels in any country, whether they are pessimistic or optimistic, are equally unreliable.

In fact, countries have had debt crises with ratios of public debt to GDP that are lower than half, and some have managed to avoid debt crises even when their public debt to GDP ratio has been more than 100 per cent for a prolonged period.  The confidence of bond markets is driven not by superior knowledge or better predictive capacity, but by a range of factors that are hard to pin down.  Indeed, it is likely that if financial markets were to be confronted by confident governments that insisted on coordinated and positive fiscal stimuli, they would respond by accepting this and bond yields would not rise so much even for weaker deficit countries.

Instead policy makers are joining the general tom-toming about the dangers of fiscal deficits.  Partly this reflects the continued political power of finance in most countries.  But it also reveals the misplaced but unfortunately common belief in each country that it can somehow export its way out of trouble.  Obviously, all countries cannot do this.  But as long as people everywhere continue to accept the nonsense currently being peddled about economic policy, the collective lemming-like march to economic self-destruction cannot be stopped.


Jayati Ghosh is Professor, Centre for Economic Studies and Planning, School of Social Sciences, Jawaharlal Nehru University, New Delhi, and Executive Secretary of International Development Economics Associates (IDEAs).  This article was first published by MacroScan on 27 July 2010; it is reproduced here for non-profit educational purposes.   See, also, James K. Galbraith, “There Is No Economic Justification for Deficit Reduction.”




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