Cuts, Pumps, or Both?

James Murphy

Someone recently asked me what my thoughts were on the austerity measures European governments are implementing and if this was the best way out of the current economic crisis.

Being a few pints in at this point, I was inclined to tell him that we’re screwed, that the problem should have been fixed 25 years ago and leave the matter at that. No wonder economics has been termed the “dismal science”!

As someone who has been educated in the study of economics, it behoved me to do a bit better than that. The way out of our current predicament is more nuanced than either paying down the debt through austerity vs. “priming the pump” by spending more money. What I tried to explain to my friend, and hope I can explain more lucidly here, is that European governments need a policy which simultaneously spends more today, and commits them to spending less public borrowing tomorrow. Such an approach would be useful in North America, too.

Before you begin, refresh your memory on what is fiscal policy.

No Quick Fix

Creditors to European governments are justifiably concerned about the ability of some of their debtor governments to make good on these loans. Even if European Central Bank took a more active role (as many have called on them to do) and created new money to buy-up bonds from the debtor nations, such a policy would inevitably push prices and interest rates upwards. Once prices and interest rates had risen, European governments would find themselves in the same position they are in now: unable to pay the bills, and at risk of default.

There are no quick-fixes here. The issue of government debt in Europe is deep-seated. If the 2008 financial crisis was the spark, it was years of structural deficits that created the power-keg which now threatens to ignite an explosive round of defaults. Public finances in Greece, Italy, and many other European countries have been precarious for years, hence the calls for austerity. The “common sense” solution would be for European governments to reduce spending. But “common sense” can be deceitful – the ability of governments to make payments on these debts depends critically on tax revenue and economic performance. Private sector spending is at an all time low – cash is being hoarded, and as a result, many jobs are either in jeopardy or outright lost. The rationale behind stimulus spending is that if private sector demand is insufficient to keep the economy rolling at capacity that government ought to step in and spend that money itself.

Dammed if you do or don’t?

This is the underlying tension between Europe’s immediate problems and Europe’s long term problems: government spending is both the solution to the short-term problem, and (part of) the long-term problem. It seems like a “damned if they do, damned if they don’t” scenario, which is why I was inclined to tell my friend that we are screwed. This is where a more nuanced approach to fiscal policy is essential. Austerity on its own will not work in Europe. A combination of short-term stimulus and long-term structural reforms is essential.

In considering the European case, two very broad characteristics of sustainable fiscal policy come to mind.

First, fiscal policy should not only boost demand in the short term to keep the economy rolling, but in order to avoid debt-crisis or inflation should also expand the economy in the longer term. What might this look like? Broadly speaking, investments in public infrastructure such as transit and electricity grids create jobs (and tax revenue) in the short-term, and if the investments are wise, pay off in the long-run. A more controversial idea would be sending unemployed workers who would otherwise be on employment insurance back to school to acquire new skills boosts productivity in the longer-term.

Second, fiscal policy should “blow against the wind”. Just as it is appropriate for governments to borrow and spend more during a recession, they ought to be more conservative in their spending and pay down the debt during the boom years. Here in North America we are not immune to this folly: the Bush tax cuts and the GST cut both undermined the ability of our governments to pay down the debt during the boom years.



Hope: A poor Hedge 

These guidelines for fiscal policy run up against some difficult political realities. Using fiscal policy to make sensible investments does not lend itself to politically sexy projects. I suspect that many voters would respond more favorably tax cuts than electricity grids. Secondly, announcing new public spending during a recession is more politically palpable than announcing tax hikes and spending cuts during a boom. Simply gutting the state will not solve European debt-problems – they are likely to exasperate it. Policy-makers must take delicate walk across a tight-rope trying to address both high debt-levels and low aggregate demand.

The road forward for Europe – a combination of stimulus spending (ideally directed to education and infrastructure) during the recession, and post-recession fiscal-responsibility – could be a road-map for sustainable fiscal policy here in North America.