The Fiscal Policy Experience Since the Great Recession

Philip Arestis and Malcolm Sawyer

In the period before the global financial crisis, macroeconomic policy was dominated by monetary policy; fiscal policy had become, at least in academic circles, largely dismissed. Governments still operated fiscal policy in the sense that budgets were presented and adjusted in light of economic circumstances. The countries of the Economic and Monetary Union of the European Union were supposedly constrained in the size of their budget deficits, though the constraints were frequently not observed.

With the global financial crisis, attention quickly swung to fiscal policy. Initially through late 2008 until early 2010, the automatic stabilisers of fiscal policy were allowed to function and budget deficits rose; there was additionally some relatively modest and temporary discretionary spending and tax reductions. At least the mistakes of the 1930s of cutting public expenditure in the face of recession were initially avoided, though unemployment rose substantially and the largest declines in GDP since WW2 were seen. It should have been self-evident that the upward swings in budget deficits were a direct result of the recession, and that attempts to reduce the deficit through austerity would undermine recovery. The sensible response should have been that, as recession caused the rise in budget deficit, recovery would bring a fall in the budget deficit. However, governments were panicked into a drive to “eliminate the deficit” whether or not the economic conditions were appropriate for deficit reduction. The panic was fostered by a “debt scare” with a focus on the often large rises in public debt, which occurred between 2008 and 2010. The idea was promoted that budget deficits were in some sense too large prior to the financial crisis, even though there was scant reason to think they had in any sense been unsustainable.

The “debt scare” was strongly influenced by the work of economists Carmen Reinhart and Kenneth Rogoff (for example, their book This Time is Different: Eight Centuries of Financial Folly) and their promotion of ideas that high public debt led to slow growth. Of particular significance was the notion that there was a cliff-edge with a sharp decline of growth for a debt to GDP ratio above 90%. Apart from noting that there is a wide range of ways of measuring public debt and which liabilities are included, there is no recognition that government has substantial infrastructure and other assets, which have often been funded by borrowing. Causal observation should have shown that the relationship did not always hold—a notable example being UK’s public debt ratio of over 250% of GDP in 1945, followed by development of the welfare state, nationalisation and a period of sustained growth. Theoretical analysis would suggest that it is slow growth and low investment which lead to high debt-to-GDP ratio, rather than the reverse. A substantial set of doubts on the work of Reinhart and Rogoff, especially their 2010 paper “Growth in a Time of Debt,” relates to the serious statistical errors in their work as demonstrated by Herndon, et al. (2014).

In the UK, it became politically convenient for the Coalition government of 2010 to 2015 to blame the previous Labour government for budget deficits, not just after the global financial crisis, but also prior to that (when the budget deficit in 2007/08 was 2.5% of GDP). In the euro area the finger was pointed at failures to enforce the Stability and Growth Pact with its aims of a balanced budget over the cycle with deficits limited to a 3% ceiling: in the relatively boom years of 2002 to 2007 budget deficits averaged 2% of GDP.

In the UK, the government put in place, in 2010, an austerity programme focused on expenditure cuts rather than tax increases and forecast to achieve a balanced budget (cyclically adjusted) by 2015. A failure to achieve that balanced budget was followed (after the election of a Conservative government) by the Code for Fiscal Stability, seeking to bind government to a balanced budget. This was abandoned two years later (following the UK’s vote to leave the EU). The Economic and Monetary Union responded with a tightening of its approaches to fiscal policy by the adoption of a “fiscal compact” (which has now been adopted by 25out of the 28 member countries of the EU) with its requirements for a “balanced structural budget.”

The “debt scare” and the pursuit of a “balanced structural budget” add to the atmosphere and pursuit of austerity. The “debt scare” leads to the view that “something must be done” or dire consequences will follow. There is little evidence to support the debt scare, yet plenty of evidence that austerity hits economic activity negatively. In a similar vein, what evidence is there that a balanced structural budget is feasible—that is, that it is possible to achieve a budget in balance and the economy operating at its “potential output”? The general record is that governments have not been operating with a “balanced structural budget.”

There were, throughout, obsessions with the size of the budget deficit—and using the scale of deficits and debt as ways of forcing through austerity and attacks on public services. The question should always be whether the fiscal position is supportive of a high level of economic activity, and the budget deficit should be large enough to support that level of economic activity—but not larger. When private sector demand is low, then potential savings are high and will become available to support budget deficit of an appropriate size. Debts accumulated from appropriate deficits can similarly be readily accommodated. Instead of fretting about the debt ratios and striving to always balance the (structural) budget, the focus should be on why a deficit is often necessary for a reasonable level of economic activity.

References

Herndon, T. Ash, M. and Pollin, R. (2014), “Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff,” Cambridge Journal of Economics vol. 38 (2), pp.257-279. doi: https://doi.org/10.1093/cje/bet075

Rogoff, Kenneth, and Carmen Reinhart. (2010) “Growth in a Time of Debt.” American Economic Review 100.2: 573–78.

Reinhart, Carmen, and Kenneth Rogoff. (2011) This Time Is Different: Eight Centuries of Financial Folly, Princeton: Princeton University Press.

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