Stimulus versus austerity: The need to balance risk

Governments should run deficits in recessions and surpluses in booms. That is the basic tenet of Keynesian economics. Deficits support demand and output during a slump, while surpluses tend to restrain a boom and pay for deficits run in the preceding cycle. It is both elegant and effective

August 16, 2010

To cut public spending in a recession might sound prudent, but actually is madness. It causes unnecessary pain and doesn’t even achieve its goal of reducing the deficit: cuts deepen the slump, tax revenues fall and the deficit remains as large as before.

Conservatives suggest that government efforts to “spend their way out of recession” crowd-out private spending because they push up interest rates, cause people to expect higher taxes in future, and hurt business confidence.

But, while the above hold when governments run deficits in a boom, they do not apply in a recession, at least not for leading countries. In a recession, market interest rates should not rise since, generally, monetary policy is loose, demand for credit is low, and investors flock to the safety of Sovereign bonds. Future tax rises will not have much effect either because people do not plan ahead that much and, even if they did, they might expect to be richer in future and thus able to pay. Likewise, business confidence would be hurt even more by failure to support demand than by a deficit.

The central objection to recessionary deficits relates to the Sovereign bond market – from which governments running a deficit must borrow. The bond market, like all financial markets, is fickle. If bond traders lose confidence in a jurisdiction, the yields it must pay on rolling-over its short term debt will rise. This harms confidence in that government further, setting up a feedback loop that drives inexorably towards default.

When expectations of the future are relatively unclouded, such effects do not kick-in and government bond yields remain roughly stable. But, in troubled times, anything could happen. Large deficits could cause a bond market panic and crash the economy. This is the most powerful argument against Keynesian economics.

But it is an argument that ignores one vital fact: failure of governments to support aggregate demand is just as likely to cause such a panic. Bond investors know, after all, that austerity which undercuts demand will also undercut the tax revenues from which they are paid.

The risks from the bond market are thus evenly balanced. This does not, however, mean we should ignore them. Rather, we should recognise that the risks change over time: budget balancing is more likely to cause panic in the early stages of a recession, while deficits that look set to continue after growth strengthens are more likely to cause this reaction at later stages.

The solution, then, is fiscal stimulus in the early stages of a recession, moderate rebalancing as recovery begins (but is still too weak for anything harsher) to convince the market that more will follow, and a move into surplus only when growth is entrenched – with the latter coming about through a combination of reviving tax revenues and deliberate fiscal adjustment.

Moderate rebalancing as growth resumes can be branded “austerity” because that is what markets need to hear. But it is really just a signal of future intent and stimulus continues for some time. This is all sensible Keynesianism, and, interestingly enough, it is what even quite conservative-sounding governments do in practice.