The Great Reversal: From fiscal expansion to fiscal austerity

The outcome of the G20 finance ministers' meeting in June in Busan, South Korea appeared to signal a major shift in the policy response to the current recession. Due to pressure from the financial markets, the policy focus is now on reducing budget deficits by slashing public spending rather than on stimulating growth through fiscal expansion. Nowhere is this change more stark than in Europe.

Jayati Ghosh

THE capitalist world economy is increasingly complex and also constantly changing, in terms of both the sources of growth and/or stagnation and the interplay between different national economies. Whether we like it or not, the G20 grouping of major economies has clearly emerged as one of the more significant ways in which economic policies are co-ordinated internationally. It is obviously not ideal, since it began simply as an expansion of the elite power grouping (the G8 industrial countries) that had effectively bypassed more democratic fora like the United Nations. But there were those who drew some comfort from the inclusion of developing economies like China, India, Brazil, South Africa and Argentina, hoping that thereby the broader concerns and aspirations of the developing world would at least find some voice. 

In the immediate aftermath of the global financial crisis, the G20 called for - and effectively achieved - the implementation of expansionary fiscal stimuli and monetary easing by all its member countries, so as to combat the massive downswing created by the crisis. Without doubt, this had a positive impact in terms of preventing a really major global crash and depression, and enabling the current recovery. It is also true that, given the shifting global political economy, such an effort would have been less successful if it had been confined to the G8 as before. Of course, if it had been part of a more extended and democratic process which involved all countries and ensured that stimulus money was directed to developing countries in greater need, it would probably have been more effective and more sustainable than what we have witnessed.

It is true that, despite this co-ordinated stimulus, the G20 had already provided several disappointments for those who were hoping that the severity of the global financial crisis would force governments of these countries to rethink the main structures and processes of international capitalism. One major disappointment was the crucial role given to the International Monetary Fund (IMF), effectively bringing back to the centre stage of global economic decision-making an institution that had lost both power and credibility. Resources and influence were once again given to the IMF, especially to provide emergency finance to countries in distress. But this was done without any real attempts at significant reform of the IMF itself or substantial change in the harsh procyclical conditionalities that it usually advocates. Another disappointment was the lack of real movement in terms of financial re-regulation, which is absolutely critical to prevent continuing financial fragility and the huge moral hazard among banks and other institutions that has emerged because of the large bailouts. Even the promise to crack down on international tax havens was riddled with so many exclusions that it was little more than a damp squib.

Reversal of course

But these disappointments of past G20 meetings pale into insignificance when compared to the outcome of the latest meeting of G20 finance ministers held in Busan, the Republic of Korea over 5 and 6 June. The previous meetings at least made vague promises and attempted measures in the right direction. But the outcome of this meeting suggests a course reversal, with governments apparently bowing to the pressure of financial markets to focus on reduction of public deficits and government debt, and that too largely through cutting expenditure rather than raising taxes even from financial activities.

The past year has been an extraordinary one for observers of economic policy changes across the world, as we have watched governments suddenly discover or relearn the economic insights of Keynes, and then almost as quickly abandon them at the first incipient signs of recovery. Nowhere is this more marked than in Europe, where monetarist orthodoxies have become especially deeply ingrained in policy making over the past generation. The differences between 'core' economies like Germany and 'periphery' economies like Ireland, Greece and Spain have already created sovereign debt problems in the eurozone.

Since Europe accounts for seven of the 20 G20 members, it may not be surprising that the theme has changed so quickly, indeed so prematurely, from fiscal expansion to fiscal discipline. But it has meant a generalisation of the crazy and unsynchronised tango between financial markets and governments which now threatens the lives of ordinary citizens not only in Europe but eventually everywhere.

The fear that is now supposedly spooking the markets is that of the possibility of sovereign default. At the frontline is Greece, the country that is being asked to impose an unbelievably severe austerity package that is bound to cause employment and incomes to spiral downwards, in return for a supposed 'improvement' in state finances, which are nonetheless projected to be in parlous condition for years to come. Just behind Greece come the next line of countries under attack, currently Spain and Portugal, and quite soon possibly the UK. Other governments that have been implementing draconian budget cuts already, like Ireland, Estonia and Latvia, still find it hard (and getting harder) to borrow money for new public debt. Now, even countries that do not seem to be under pressure from financial markets (like France) and those that cannot possibly be under pressure because they have large current account surpluses (like Germany) are also announcing budget cuts and moves to fiscal austerity.

Procyclicality

The funny thing is that, the more the governments announce budget cuts and other measures to squeeze out savings in the economy, the worse the hit that their bond markets seem to take. Interest rate spreads have been rising and signs of investor panic in sovereign debt markets spread just as governments try to placate markets by bowing to their pressures to cut government deficits. So, instead of being rewarded for good behaviour by the financial markets, they are being further punished.

What exactly is going on? It is really a case of the stupidity of markets being magnified by the apparently even greater stupidity of economic policy makers, who seem to be undertaking knee-jerk responses to changes in market sentiment, rather than engaging in strategies based on an appreciation of actual macroeconomic processes. As a result, their actions serve to generate precisely the opposite tendency from what was desired, thereby causing further financial panic.

Consider the current situation. The global economy is recovering from a major recession but the recovery is fragile, uneven and easily reversible. It is fairly obvious - and indeed was universally recognised in the midst of the financial crisis in 2008 - that when private economic agents are caught in a liquidity trap or in a deflationary spiral, governments must increase their own spending and ease access to credit to keep the economy going. If they also cut spending and tighten monetary policy, they will worsen the downswing and possibly even cause a deep depression. In other words, macroeconomic policy should be countercyclical, not procyclical.

The only way this can be avoided is if the economy concerned tries to rely on global markets and increase its net exports, or if the attempt at stabilisation somehow makes the economy appear very attractive to foreign investors who rush in to invest (which is typically very unlikely in a stagnant or declining market). The dependence upon foreign markets is why the IMF typically has advised this brutal combination of fiscal and monetary tightening to countries in deficit, effectively bringing on even sharper slumps in many of the countries that have taken their medicine.

The recent increase in Chinese exports (which went up by nearly 50% in the year to May 2010) has given further hope to export obsessors, who believe that the engine of growth can come from elsewhere. Germany - the other very large global exporter - clearly expects that the fall in the euro as a result of the market jitters will help it to use the same strategy. But obviously, this is not something that all countries together can hope to do. So if all countries expect that external markets will save them, then all of them will sink together. But that is precisely what all the economies in Europe are collectively expecting.

This has another predictable result, which is that the attempt to reduce the fiscal deficit can become self-contradictory. Governments cut their spending and impose austerity measures. This then reduces incomes and employment immediately, and over time through the negative multiplier effects. As a result, government tax revenues come down. This can even lead to a worse fiscal deficit than before, as many countries have found in the past. In fact it is well known that since tax revenues go down in a crisis or a recession, the fiscal deficit is bound to increase. Policies that aggravate the slump will only make it worse.

Now consider how this plays out in interaction with private financial markets. When private investors apparently decide that a country's level of government debt is 'too high' or that it has current account or fiscal imbalances that are 'too large', the spread on interest on that government's debt rises. Bond yields rise as bond prices fall. The country finds new borrowing more difficult and/or more expensive. The government then decides that it has to cut back on spending in order to reduce the deficit. The markets (or at least the financial media) applaud this decision. But then the cutbacks cause more economic pain in terms of reduced incomes and employment, which makes the growth prospects worse. So financial markets respond by further increasing the spreads on government debt! And so on. In fact, the prescription for austerity in these countries is bizarre because it undermines the foundations for economic growth without which they will never be able to repay existing debts.

This ridiculous drama can go on for a while, and the only thing that can stop it is decisive government action. In fact, given the difficulties of individual countries trying to use fiscal stimulus in a world of mobile capital, the only real way out of this peculiar trap is for coordinated fiscal stimuli to continue, and to focus especially on increasing employment. The G20 meeting in Busan would have been a good platform to announce that plan and thereby prevent markets from picking on and attacking individual economies.

Shift in Busan

Instead, the G20 announced very different - even opposite - intentions! The communique from the Busan G20 meeting declares that 'The recent events highlight the importance of sustainable public finances and the need for our countries to put in place credible, growth-friendly measures, to deliver fiscal sustainability, differentiated for and tailored to national circumstances. Those countries with serious fiscal challenges need to accelerate the pace of consolidation. We welcome the recent announcements by some countries to reduce their deficits in 2010 and strengthen their fiscal frameworks and institutions.'

The shift from a focus on growth and employment to fiscal 'consolidation' (read retrenchment) was apparently led by the new British Chancellor of the Exchequer, George Osborne, who has made the Tory obsession with fiscal austerity something of a rallying cry for the newly elected Conservative-Liberal coalition government in the UK. But it reflected a growing view across leaders, particularly in Europe, that private market sentiment is now focused on budget deficits, and that this could rebound on growth prospects if shifts in investor sentiment caused large-scale capital outflows.

This was evident by the end of the first week of June, when the government in Hungary scrambled to reassure markets as the currency collapsed after the new Economy Minister rashly spoke of a possible 'Greek-style crisis' because of supposed fiscal cover-ups by the previous government. Similarly the French were forced to take note that simply loose talk by leaders about deficits can be dangerous and can threaten the French government's triple A rating in bond markets, even when public finances are basically sound.

The irony is that when all these G20 governments announce that they will aim at fiscal consolidation, the outcome is likely to be counterproductive even on their own terms. Obviously, such a focus will adversely affect output and employment growth at a time when the global recovery is still fragile. And, as noted above, when growth prospects are lower, private market sentiment will also be affected, and private investment is much less likely to make up the difference to prevent renewed recession. Indeed, on 7 June markets across the world fell, probably depressed not just by fears regarding government debts, but also by the suspicion that the cure may be worse than the illness.

This completely wrong-headed response has ensured that the roller-coaster ride in global financial markets will continue to inflict pain on real economies everywhere. Not for nothing has Mohamed El-Erian, the head of the major transnational financial firm Pimco, announced that 'investors should keep their seat belts on and tight.'

Quite apart from the fact that is evident from the response of the financial markets, that this is no time to be enforcing fiscal discipline, even the methods proposed are wrong-headed. Cutting back on public spending is only one of the ways to reduce what are seen as excessive budget deficits. When it involves more unemployment (as in Greece, or in the UK where it is estimated that half a million jobs will be lost through the proposed austerity measures), it pushes an economy further into recession. A more effective method, which is usually less painful for the average citizen, is to increase taxes particularly on the more wealthy. Insofar as the wealthy tend to save a higher proportion of their income, the adverse multiplier effects of such a measure on economic activity and employment would also be correspondingly less.

Bank levy

One major item on the G20 agenda was the coordinated imposition of a levy on banks, a move that would have been positive on several fronts. It would have brought in much-needed tax revenues, forced banks to pay at least partly for the large bailouts they had required, and imposed some discipline on their activities. But, like most good ideas, this one came up against a lot of opposition, led in this case by the Canadian and Australian governments and fuelled by bank lobbyists in all countries who had actively campaigned against such a measure. In the event, no such levy was announced. Of course, governments are still free to impose such taxes within their own countries, but fears of banks shifting their capital away to non-tax countries are likely to keep such taxes so low as to be practically irrelevant. Meanwhile, there were no more than platitudes on financial regulation, including the (by now embarrassing) reiteration of the belief that stronger prudential norms can prevent future financial crises.

So what has the developing world got out of the latest G20 meeting? And what have even the subset of developing countries who are lucky enough to be members got out of it? Remarkably, almost nothing. There was no mention of the regrettable pro-cyclicality of aid, which has shrivelled to embarrassing levels in the North since the onset of the crisis. Even in terms of reforming the multilateral donor organisations to make them more democratic, the official communique was reduced to welcoming the agreement on the World Bank's voice reform to increase the voting power of developing and transition countries by a paltry 3.13%, with some worthy platitudes about the IMF.

In fact, the outcomes of the G20 meeting are actually likely to be adverse for the developing world. Even the head of the IMF, Dominique Strauss-Kahn, noted that 'fiscal consolidation in advanced economies has big and, of course, negative effects on emerging countries.' The reason is that as the budget retrenchment hits effective demand in these economies, as it must, it also and necessarily affects imports, so that exports of the developing world are likely to suffer. Meanwhile, since everyone is now trying to export their way out of economic trouble, a phase of competitive beggar-thy-neighbour devaluations seems only too possible, adding currency instability to all the other woes of developing countries. 

It will take a lot more for most people in the developing world to feel even minor satisfaction that the governments of a few developing countries have managed to gain admittance at the high table of international power brokers. And meanwhile they will continue to suffer from the imposition of macroeconomic policies that reduce their chances of stable employment and viable livelihood.     

Jayati Ghosh is a Professor of Economics at Jawaharlal Nehru University in New Delhi.

*Third World Resurgence No. 237, May 2010, pp 13-16