experiencing. The current fiscal tightening is arguably contractionary, but the alternative of not reacting to the credibility loss would have produced much worse consequences.
Things are more complex for the UK; it hasn’t lost credibility and it borrows at low interest rates. Does this mean UK policymakers are shooting themselves in the foot?
Are they keeping the economy underemployed for years and thus destroying potential output with their austerity drive? Or, are they wisely forestalling a bond market rebellion like those seen on the continent that would prove much costlier?
Much of the work carried out in the PEGGED project over the years provides a conceptual and analytical framework to address these issues. The question of course is not only about restoring safer fiscal positions after the large increase in gross and net public debt in the last few years. Rather, it is about which fiscal policy path would be most effective in helping the global economy and the economy of the Eurozone overcome the current crisis.
This issue requires solution both at country-level, and at regional and global level.
International considerations complicate the analysis; a policy which may be perfectly viable and desirable for a country conditional on an international context, may not work in different circumstances. The outcome will depend on the degree of international cooperation, especially in the provision of liquidity assistance and in the establishing of
‘firewalls’ against contagion.
Fiscal policy at a crossroads: Self-defeating tightening in a liquidity trap?
Recent contributions about the mechanism through which fiscal contraction in a liquidity trap is counterproductive have led to an important change in perspective, relative to initial views.
A key point here is the recognition that much of the advanced world is currently in an unemployment and underemployment crisis. Destruction of jobs and firms today may
Fiscal consolidation and macroeconomic stabilisation
be expected to have persistent effects on potential output in the future. These effects in turn translate into a fall in permanent income, and hence demand, today (see DeLong and Summers 2012 and Rendahl 2012).
In a liquidity trap, this creates a vicious self-reinforcing circle. Today’s unemployment creates expectations of low prospective employment, which in turn causes an endogenous drop in demand, reducing activity and raising unemployment even further. This vicious cycle may have little to do with price stickiness and expectations of deflation at the zero lower bound, an alternative mechanism which was stressed early on by Eggertsson and Woodford (2003) and more recently by Christiano et al (2011). Independently of deflation, the vicious cycle can be set in motion by expectations of lower income when shocks create a high level of persistent underemployment. Theory suggests that this effect can be sizeable. The question is its empirical relevance.
The empirical evidence indeed weighs towards large multipliers at a time of recession and especially at times of banking and financial crises (Corsetti et al 2012), as opposed to very small multipliers when the economy operates close to potential and monetary policy is ‘unconstrained’. The point estimate of the multiplier conditional on crises is of the order of 2 – a value not far from the one used by several governments and commentators, but higher than most estimates in the literature that fail to distinguish across different states of the economy. In light of these results, it can be safely anticipated that the current fiscal contractions will exert pronounced negative effects on output.
It is worth stressing that fiscal adjustment is currently happening at different levels of government – both central and local. An analysis of spending multipliers at local level carried out in the context of the PEGGED model suggests that differences in cuts and budget adjustment at subnational level can also generate sizeable contractionary effects on the local economy, holding constant the macroeconomic conditions at national level.
This is the paper by Acconcia et al (2011) on provincial multipliers in Italy, which takes advantage of the quasi-experimental setting generated by the Italian law mandating the dismissal of city councils on evidence of mafia infiltration. When a city council
is dismissed, the commissaries sent by the government ensure that the administration keeps working according to national standards, but suspend public works. This generates a spending contraction of the order of 20%. The multiplicative effects on output, calculated holding monetary policy constant, are of the order of 1.2 or 1.4.
This is why, with a constrained monetary policy, there is little doubt that governments with a full and solid credibility capital should abstain from immediate fiscal tightening, while committing to future deficit reduction. The virtues of such a policy are discussed in the aforementioned PEGGED paper by Corsetti et al (2010).
The problem is that, in the current context, promising future austerity alone may not be seen as sufficiently effective. Keeping markets confident in the solvency of the country has indeed provided the main motivation for governments to respond to nervous financial markets with upfront tightening.
The challenge: How to stabilise economies with high and volatile sovereign risk
In a recent PEGGED paper, Corsetti et al (2012) (henceforth CKKM) highlight issues in stabilisation policy when the government is charged a sovereign-risk premium. The root of the problem is the empirical observation that sovereign risk adversely affects borrowing conditions in the broader economy. The correlation between public and private borrowing costs actually tends to become stronger during crises. Perhaps in a crisis period high correlation is simply the by-product of common recessionary shocks, affecting simultaneously, but independently, the balance sheets of the government and private firms. Most likely, however, it results from two-way causation.
In the current circumstances, there are good reasons to view causality as mostly flowing from public to private. First, in a fiscal crisis associated with large fluctuations in sovereign risk, financial intermediaries that suffer losses on their holdings of government bonds may reduce their lending. Second, both financial and non-financial firms face a
Fiscal consolidation and macroeconomic stabilisation
higher risk of loss of output and profits due to an increase in taxes, an increase in tariffs, disruptive strikes and social unrest, not to mention lower domestic demand.
There are at least two implications for macroeconomic stability of this ‘sovereign-risk channel of transmission’ linking public to private borrowing costs.
First, if sovereign risk is already high, fiscal multipliers may be expected to be lower than in normal times. The presence of a sovereign-risk channel changes the transmission of fiscal policy, particularly so when monetary policy is constrained (because, for example, policy rates are at the zero lower bound, or because the economy operates under fixed exchange rates). When sovereign risk is high, the negative effect on demand of a given contraction in government spending is offset to some extent by its positive impact on the sovereign-risk premium.
Some exercises by CKMM suggest that, typically, consolidations will be contractionary in the short run. Only under extreme conditions does the model predict either negative multipliers (in line with the view of ‘expansionary fiscal austerity’) or counterproductive consolidations (in line with the view of ‘self-defeating austerity’). To the extent that budget cuts help reduce the risk premium, there is some loss in output, but not too large.
Second, due to the sovereign-risk channel, highly indebted economies become vulnerable to self-fulfilling economic fluctuations. In particular, an anticipated fall in output generates expectations of a deteriorating fiscal budget, causing markets to charge a higher risk premium on government debt. Through the sovereign-risk channel, this tends to raise private borrowing costs, depressing output and thus validating the initial pessimistic expectation.
Under such conditions, conventional wisdom about policymaking may not apply. In particular, systematic anti-cyclical public spending is arguably desirable when policy credibility is not an issue. In the presence of a volatile market for government bonds, however, anticipation of anti-cyclical fiscal policy may not be helpful in ensuring macroeconomic stability. A prospective increase in spending in a recession may lead to
a loss of confidence by amplifying the anticipated deterioration of the budget associated with the fall in output.
This possibility poses a dilemma for highly indebted countries. In light of the above considerations, countries with a high debt may be well-advised to tighten fiscal policies early, even if the beneficial effect of such action – prevention of a damaging crisis of confidence – will naturally be unobservable. From a probabilistic perspective, even a relatively unlikely negative outcome may be worth buying insurance against if its consequences are sufficiently momentous. In the current crisis, unfortunately, we know that such insurance does not come cheap.
Beyond country-level fiscal correction
The near-term costs of austerity mean we should keep thinking about alternatives, such as making commitments to future tightening more credible (eg the reform of entitlement programmes). However, the presence of a sovereign-risk channel also provides a strong argument for focusing on ways to limit the transmission of sovereign risk into private-sector borrowing conditions.
Strongly capitalised banks are a key element here. The ongoing efforts, coordinated by the European Banking Authority, to create extra capital buffers in European banks correspond to this logic. Another element is the attempt by monetary policymakers to offset high private borrowing costs (or a possible credit crunch) when sovereign-risk premium is high.
Normally, the scope to do this is exhausted when the policy rate hits the lower bound.
Recent unconventional steps by the ECB, however, suggest that more is possible. The extension of three-year loans to banks, in particular, appears to have reduced funding strains, with positive knock-on effects for government bond markets.
These arguments are especially strong, either for countries already facing high interest rates in the market for their debt, or for countries reasonably vulnerable to confidence
Fiscal consolidation and macroeconomic stabilisation
crises. These countries would be ill-advised to relax their fiscal stance. The arguments apply less to governments facing low interest rates. The main issue is where to draw the line.
References
Acconcia, A, G Corsetti, and S Simonelli (2011), Mafia and Public Spending: Evidence on the Fiscal Multiplier from a Quasi-experiment, CEPR DP 8305.
Christiano, L, M Eichenbaum, and S Rebelo.(2011) When is the government spending multiplier large? Journal of Political Economy, 119(1):78–121.
Cottarelli, C (2012), “Fiscal Adjustment: too much of a good thing?”, VoxEU.org, February 8.
Corsetti, G, A Meier and G Müller (2009), “Fiscal Stimulus with Spending Reversals”, CEPR discussion paper 7302, 2009, Forthcoming, The Review of Economics and Statistics.
Corsetti, G, K Kuester, A Meier, and G Müller (2010), “Debt consolidation and fiscal stabilisation of deep recessions”, American Economic Review: P&P 100, 41–45, May.
Corsetti, G, K Kuester, A Meier, and G Müller (2012), “Sovereign risk, fiscal policy and macroeconomic stability”, IMF Working paper 12/33.
Corsetti, G, A Meier, and G Müller (2012) “What Determines Government Spending Multipliers?” Prepared for Economic Policy Panel in Copenhagen April.
DeLong, B and L Summers (2012) Fiscal Policy in Depressed Economy,
Eggertsson, G B and M Woodford (2003), “The zero interest-rate bound and optimal monetary policy”, Brookings Papers on Economic Activity, 1:139–211.
Rendahl, P (2012), Fiscal Policy in an Unemployment Crisis, Cambridge: Cambridge University Press.
About the author
Giancarlo Corsetti is Professor of macroeconomics at the University of Cambridge. On leave from the University of Rome III, he previously taught at the European University Institution, as Pierre Werner Chair, the Universities of Bologna, Yale and Columbia.
His main field of interest is international economics. His main contributions to the literature include general equilibrium models of the international transmission mechanisms and optimal monetary policy in open economies, analyses of currency and financial crises and their international contagion, and models of international policy cooperation and international financial architecture. He has published articles in many international journals including American Economic Review, Brookings Papers on Economic Activity, Economic Policy, Economics and Politics, European Economic Review, Journal of Economic Dynamics and Control, Journal of Monetary Economics, Quarterly Journal of Economics, Review of Economic Studies, and the Journal of International Economics. He has co-authored an award-winning book on the 1992-93 crisis of the European Monetary System, Financial Markets and European Monetary Cooperation. He is currently co-editor of the Journal of International Economics.
Giancarlo Corsetti is Research Fellow of the Centre for Economic Policy Research in London, where he serves as Director of the International Macroeconomic Programme;
and a member of the European Economic Advisory Group at CESifo in Munich, publishing a yearly Report on the European Economy. Professor Corsetti has been a scientific consultant to the ECB and the Bank of Italy, and a visiting scholar at the Federal Reserve Bank of New York and the IMF.
Richard Portes
London Business School and CEPR