Economists are usually an argumentative bunch. Whether it was Martin Feldstein or Milton Friedman, they usually can never seem to come to agreement on issues of global finance, macroeconomics or decisions made in the financial world. As George Bernard Shaw once famously said, “If all economists were laid end to end, they’d never reach a conclusion”.
One of the most famous debates in the past 10 years has been that of “Stimulus versus Austerity”. It began mostly when the United States needed to respond to financial crisis, the Great Recession in 2008. The debate has resurfaced in the past year due to the austerity measures that Greece was forced to take up so that it would receive its bailout package from the IMF and EU. Let’s understand the two arguments and see whether both measures are justified and are a way out of financial crises.
The debate is rooted in Keynesian economics that views monetary easing and fiscal stimulation as the way to restart growth during crises. The growing economy helps pay debts and thus mitigates the debt crisis, the basic idea is to “grow out of the debt overhang”.
On the other hand the aim of austerity is to make sure markets return to their normal functioning. The logic behind it is that after the explosion of a financial bubble, investors became concerned about state and household debts. They hoard liquidity and thus refuse to invest in securities issued by heavily indebted entities, hence protracting the economic slump by denying credit to the real economy. Thus immediate reduction in debt is seen because of the loss in confidence. A combination of this with tax cuts and fiscal consolidation ensures the economy restarts and returns to normalcy.
The Great Recession
The Great Recession that began in December 2007 and lasted till June 2009 was the time when the dilemma between choosing the Fiscal stimulus or Austerity policies was at its peak. The loss of wealth during the time led to huge cutbacks in consumer spending.
Basically, the commercial banks were giving mortgages to people who couldn’t afford them. These mortgages were pooled together into securities, this meant that the risk was spread out. These securities were bought by commercial banks and normal investment banks as well (the commercial banks had essentially become investment banks because of the repeal of the Glass-Steagall Act). These securities were converted into derivatives and banks bet on the performance of these derivatives.
As the economy fell in September when the housing bubble burst, the rest of the world was affected. This was mainly because other commercial banks from across the world had funded the investment banks for the increase of leverage and to buy more CDO’s. They lost a lot of the depositors savings in this scam because the companies couldn’t repay them back and thus with this the whole world’s economy went into a meltdown.
Measures taken by the United States
The then secretary of the United States treasury, Henry Paulson, and George W. Bush Jr. proposed a 700 billion dollar relief fund to be provided by the government, known as TARP (Troubled Asset Relief Program). After much debate by the Secretary and his committee (that was largely made up of ex- Goldman and Sachs employees), the bill finally got passed by Congress and the money that was used in the bailout was the taxpayers money. Half of the money was used to buy up the failed derivatives and to make the toxic assets safe. The other half went into giving the employes of the bailed banks raises.
There was uproar as people wanted to know why Main street was bailing out Wall Street, it was unfair that the citizens had to pay for the bankers’ mistakes and greed. At the time there was also fewer dollars in Europe and the reserve announced that it would increase its swap facilities from 290 billion dollars to 620 billion dollars.
A few months later another 800 billion dollar debt was bought by the Fed, in order to buy more mortgage backed securities and to buy up Freddie Mac and Fannie Mae. Another 200 billion was used to unfreeze the consumer debt market. Totally the Fed had used up more than 1.2 trillion dollars to bailout the AIG, Fannie Mae and Freddie Mac, Citigroup and to sell Bear Stearns.
This system of pumping in money to revive the system was known as ‘stimulus’. By 2013 the economy has revived itself and the Fed slowed down its stimulus.
Europe’s response to the crisis
Spain didn’t bail out its banks but the biggest bailout was handed out by Germany. Angela Merkel and her cabinet compiled a 50 billion euro bailout plan.
France’s president at the time, Nicolas Sarkozy, announced a 26 billion euro rescue plan, along with an additional 15.5 billion euro addition to the normal budget to increase France’s 4% deficit.
Gradually we may notice that rates of unemployment and the lowering of budget deficit is the way one may evaluate austerity’s impacts. Also the rise in taxes and the interest rates point towards the success or failure of austerity measures.
Generally across the world markets tried to revive themselves and pull themselves out of the mess. The biggest mistake many of them made, was to devalue their currencies in order to up their exports. As the currency got cheaper, more of your products were bought by foreign countries. Also more foreign countries would invest in the country and pump money into it, thus erasing the budget deficit. But this may lead to runaway inflation and it may not help the economy, because if the currency devalues too fast then there is risk and people are often not confident about their investments in countries with tumbling values.
The arguments for stimulus are many and are as mentioned below:
Firstly, fiscal stimulus is implemented because it is thought that by cutting taxes and through government spending, people will buy more and the GDP will go up.
Though some may argue that fiscal stimulus leads to ‘crowding out’, defined as the government borrowing leading to higher interest rates that in turn may offset the stimulative impact of government spending. When the government runs a budget deficit, funds will need to come from public or foreign borrowing, as a result, the government issues bonds. The issuance of bonds, may result in an increase in interest rates across the markets, because government borrowing creates higher demands for credit in the financial markets. This may in turn cause a lower aggregate demand for goods and services, contrary to the objective of stimulus.
But with unemployment rates high and the demands for loans low, there was little risk that the government would crowd out private activity. Secondly, since households were forced to pay of their loans quickly, a boost in their incomes ensured that they did so quickly.
Thirdly, because the government was investing in the economy it was natural that there would be an increased multiplier effect compared to the value of the multiplier while taking austerity measures.
However, with monetary policy at near-zero rates (or even at negative real interest rates), economic expansion requires either innovations such as quantitative easing or traditional increases in fiscal expenditures. Both of these options carries some risks. Under some unlikely but plausible circumstances, quantitative easing could escalate into a practical equivalent of monetary financing of government debt, which could trigger high levels of inflation. However, this risk is far in the future and can be mitigated if central banks are able to withdraw the monetary stimulus at the right point in time. Thus arguing against stimulus by saying that there is immense risk is false because it can be seen that the banks can regulate possible flaws and problems to prevent risks.
An argument against expansionist policy is that to pump money into the economy, often countries need to borrow money thus increasing their debt. Thus expansionist policy is ideal only for countries with less debt and relatively steady economies.
Essentially the argument for fiscal stimulation is to “solve debt with more debt” thus it lacks political appeal. According to a study by the Czech Republic government, economies that were deeply affected by the crisis, preferred expansionist policy. Countries that were pro austerity were either less affected and they wanted the government to focus on reducing debt while increasing growth.
On the other hand, the arguments for austerity are fewer. They are as follows:
Firstly the arguments pro austerity rely on the confidence of investors after a crisis. Since investors will become concerned about the debt states and companies hold, they won’t invest in markets, thus hoarding liquidity and denying the markets credit. This means that it will reduce the debt immediately.
Secondly, through tax cuts and fiscal consolidation, the public deficit gets converted to surplus thus enabling debt repayment. One may also liberalize and privatise protected professions to boost growth. Also bringing in structural reforms in regulation, over-leveraging and uncynical behaviour of markets, will prevent risks and meltdowns in the future.
Most Austerians do not deny that to restart growth is the best way towards recovery, but they do agree that the short term pitfalls are more.
Overall, if one observes the different measures taken by governments during the 2008 crisis for example, indicate that a combination of the two measures helps economies. It is the value of the fiscal multiplier that works as the main indicator of success or failure of a policy. One may see how in different ways different institutions have taken different measures to make sure their economies bounce back. These means may not always be justifiable, but they are often extremely successful. The measures that seem to have been taken were usually those of cutting back on government expenditure or pumping in a lot of money to revive the economy. To conclude, one may say that it depends on what kind of economy the government follows and whether it is entrenched in a means of social justice and welfare or in a stricter capitalist system. At different times in different areas, governments may choose to use either of the measures and may be highly successful.