Expansionary Fiscal Consolidation Myth

Anis Chowdhury and Jomo Kwame Sundaram

The debt crisis in Europe continues to drag on. Drastic measures to cut government debts and deficits, including by replacing democratically elected governments with ‘technocrats’, have only made things worse. The more recent drastic expenditure cuts in Europe to quickly reduce public finance deficits have not only adversely impacted the lives of millions as unemployment soared. The actions also seem to have killed the goose that lay the golden egg of economic growth, resulting in a ‘low growth’ debt trap.

Government debt in the Euro zone reached nearly 92 per cent of GDP at the end of 2014, the highest level since the single currency was introduced in 1999. It dropped marginally to 90.7 per cent at the end of 2015, but is still about 50 per cent higher than the maximum allowed level of 60 per cent set by the Stability and Growth Pact rules designed to make sure EU members “pursue sound public finances and coordinate their fiscal policies”. The debt-GDP ratio was 66 per cent in 2007 before the crisis.

High debt is, of course, of concern. But as the experiences of the Euro zone countries clearly demonstrate, countries cannot come out of debt through drastic cuts in spending, especially when the global economic growth remains tepid, and there is no scope for the rapid rise of export demand. Instead, drastic public expenditure cuts are jeopardizing growth, creating a vicious circle of low growth-high debt, as noted by the IMF in its October 2015 World Economic Outlook.

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Unfounded Debt Fears Block Economic Recovery

Anis Chowdhury and Jomo Kwame Sundaram

Debt anxieties are not new, often fanned by political competition. But so is a double dip recession due to premature deficit reduction. For example, to seek re-election, President Roosevelt backed down from his New Deal in 1937, promising that “a balanced budget [was] on the way”. In 1938, he slashed government spending, and unemployment shot up to 19 per cent.

Deficits and debt

Many countries had huge public debts when World War II ended. Despite such anxieties and calls for drastic spending cuts, governments continued to spend. Had they caved in, Europe would not have been rebuilt so soon. As governments continued with massive expenditure to rebuild their countries, economies grew and the debt burden diminished rapidly with rapid economic growth. Clearly, debt is sustainable if government expenditure enhances both growth and productivity.

When the debate about deficits and public debt was raging during the Great Depression, Evsey Domar, growth theory pioneer, noted, “Opponents of deficit financing often disregard … completely, or imply, without any proof, that income will not rise as fast as the debt … There is something inherently odd about any economy with a continuous stream of investment expenditures and a stationary national income.”

After the 2008-2009 financial meltdown brought many OECD economies to a standstill, there was a brief revival of fiscal activism. Many OECD governments initially responded with large fiscal stimulus packages, while bailing out influential financial institutions. Major developing countries also put in place well designed fiscal stimulus packages including public infrastructure investment and better social protection.

Hence, there were sudden increases in debt/GDP ratios, mainly due to large financial bail-out packages and some fiscal activism. But with the first hints of “green shoots” of recovery from mid-2009, fiscal hawks stepped up their calls for winding back, sounding dire warnings about ballooning deficits. They argued that rapid fiscal consolidation would boost confidence, particularly in the finance sector, creating an expansionary impulse.

Thus, the affected countries undertook rapid fiscal consolidation measures with large cuts in public expenditure, especially in the areas of health, education, social security and infrastructure. Yet, their debt-GDP ratios continue to rise as they struggle to reignite growth. Meanwhile, the IMF has admitted that its initial fiscal consolidation advice was based on erroneous ad-hoc calculations.

Overwhelming recent research findings, including from the IMF, indicate that discretionary counter-cyclical fiscal policy in recessionary periods augments and catalyses aggregate demand, encourages private investment and enhances productivity growth, instead of raising interest rates and crowding-out private spending.

Optimal debt-GDP ratio?

The fixation with a particular debt-GDP ratio lacks any sound basis. The 60 per cent debt-to-GDP ratio, used by the European Commission and the IMF as the upper threshold for fiscal sustainability by 2030, was simply the median pre-crisis ratio for developed countries and the median debt-GDP ratio of EU countries at the time of the Maastricht Treaty. Similarly, the 3 per cent budget deficit rule of the EU happened to be the median budget deficit ratio at the time of the Treaty. None of these ostensible bench-marks imply optimality in any meaningful, economic sense.

Public debt in Japan soared to well over 200 per cent of GDP over two and a half decades of deflation. Yet, interest rates have remained low for many decades. In 1988, Belgium had the highest public debt, and Italy’s debt rose above 100 per cent of GDP during this period. Neither of them experienced spiraling inflation or very high interest rates as ‘austerity hawks’ claim will happen when government fiscal deficits rise. Meanwhile, studies of public finance in the United States do not find any significant relationship between debt-to-GDP ratios and inflation or interest rates during 1946-2008.

However, real interest rates may be adversely impacted by whether the debt is denominated in domestic or foreign currencies. In other words, a sovereign country should have the option to monetize debt. The problem arises when that option does not exist, as with countries in the Euro zone. This is clear from the contrasting experiences of Spain and the UK during the recent rapid public debt build-up.

The UK public debt-GDP ratio was 17 percentage points higher than the Spanish Government debt (89 versus 72 per cent) in 2011. Yet, the yield on Spanish government bonds rose strongly relative to the UK’s from early 2010, suggesting that international bond markets costed Spanish risk much more than UK government bonds.

As a member of a monetary union, Spain does not have control over the currency in which its debt is issued, while UK public debt is mostly in its own currency, as in the US and Japan. Therefore, much of the problem in the Euro zone is not really about high public debt or deficits. Rather, it is rooted in the currency union that limits its members’ policy space with regard to money creation and exchange rate policy. Hence, the only way they can improve what is seen as competitiveness is by cutting wages!

Then and now

Since 2014, even the IMF has changed its stance. In its October 2014 World Economic Outlook, it advised that “debt-financed projects could have large output effects without increasing the debt-to-GDP ratio, if clearly identified infrastructure needs are met through efficient investment”.

There is, of course, one difference between now and the 1930s. The finance sector and rating agencies are much more influential and powerful now than then. Democratically elected governments have become hostage to money-market investors who shift money from one place to another in search of quick profits.

Governments should not be driven by superficial diagnoses of complex economic issues by rating agencies. The record of rating agencies before the 2008 global economic crisis was abysmal, and the US Congress has seriously debated whether they should be prosecuted. Trying to win their confidence is futile, and trying to anticipate them is hazardous, but they nevertheless hold finance ministries and central banks to ransom.

Originally published by Inter Press Service.

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Enforcement of Puerto Rico’s Colonial Debt Pushes Out Young Workers

“Compromise” protects vulture funds, not Puerto Rico

José A. Laguarta Ramírez

At least 23 of the 49 people killed in the mass shooting that took place at Pulse nightclub in Orlando on June 12 were born in Puerto Rico. While the horrendous hate crime targeted LGBT people of all ethnicities, the large proportion of island-born casualties is not surprising, as the central Florida city has become a preferred destination of Puerto Rican migrants over the past two decades. Steadily growing since the onset of the island’s current “fiscal” crisis in 2006, yearly out-migration from Puerto Rico now surpasses that of the 1950s. The island’s total population has begun to decline for the first time in its history.

Nearly a third of the island-born victims of the Orlando massacre were 25 or younger, most of them students employed in services or retail. This is the population group that will be hit hardest when the ironically named Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) comes into effect. Among its other “promises” for working-class Puerto Ricans, PROMESA will cut the minimum wage in Puerto Rico for those under 25, from the current federally mandated $7.25 to $4.25 per hour, and scale back the federal nutritional assistance program on the island. Purportedly aimed at “job-creation,” these measures will likely intensify the outflow of able-bodied “low-skilled” workers. Ongoing out-migration has already decimated the number of available healthcare and other professionals on the island. Puerto Rico’s 2013 median household income of $19,183 was barely half that of Mississippi, the poorest U.S. state (at $37,479), despite a cost of living that rivals that of most major cities in the United States. Inequality on the island is also greater than in any of the states.

The U.S. House of Representatives approved PROMESA on the evening of June 9, following a strong endorsement by President Barack Obama. The bill, which would also impose an unelected and unaccountable federal oversight board and allow court-supervised restructuring of part of the island’s $73 billion debt, now awaits consideration by the Senate. Its advocates hope the president can sign PROMESA into law before July 1, when $1.9 billion’s worth of Puerto Rico general obligation bonds will come due. Unlike those issued by public utility corporations and certain autonomous agencies, general obligation bonds, under Puerto Rico’s colonial constitution, must be repaid before any further public spending for the following fiscal year is authorized. Puerto Rico’s government has partially defaulted three times within the past year, but not on general obligation bonds. Puerto Rico is not the only place, under the global regime of austerity capitalism to face predatory creditors and the imposition of unelected rulers —as illustrated by cases like Argentina, Greece, and post-industrial U.S. cities such as Flint, Mich.— but its century-old colonial status has made it particularly vulnerable and defenseless.

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After the “Battle of the Century”

What next for debt crisis management?

Bodo Ellmers

Bodo Ellmers is Policy and Advocacy Manager at the European Network on Debt and Development (Eurodad).

In late April, the ‘battle of the century’ between the government of Argentina and a group of vulture funds reached an inglorious end. The government of Argentina finally surrendered and paid the vulture funds in full, at a price tag of more than US $10 billion. The consequences are severe: Argentina started a new cycle of indebtedness; the vulture funds’ predatory business model has been further strengthened and threatens to affect more and more nations; and future debt crisis management in general is in a mess. Now this battle has been lost, the question remains: what next for debt crisis management?

Argentina: back to markets or back to debt crisis?

Argentina had to borrow the money it needed to pay the vultures, thus it returned to financial markets after more than a decade of absence. To the surprise of many financial market observers, the bond issue of the former pariah state was hugely oversubscribed. In the largest emerging market issuance ever, Argentina managed to raise US $16.5 billion in three different bond series that yielded on average 7.2%. This successful return has the caveat that it starts a new cycle of indebtedness. While the government of Argentina hopes that the ‘normalisation’ of financial relations will attract foreign investment, none of these borrowed dollars will be invested productively. The lion’s share of more than US $10 billion went to pay the vulture funds; the smaller share replenished Argentina’s depleted currency reserves, i.e. mainly to refinance capital flight.

The issuance was a perfect deal for investors. It soon turned out that Argentina had sold the bonds too cheaply. Prices surged in the first few days, allowing the banks that were the bookrunners to make quick profits. JP Morgan celebrated: “These yields don’t exist anywhere else in the world in countries with such low levels of debt.”

Argentina’s citizens are paying the price for their government’s strategy of pleasing foreign investors. The recent removal of exchange restrictions has resulted in a 40% currency devaluation and a spike in inflation. Subsidies on essential services have been removed and, by March 2016, 32,000 public service workers had been laid off.

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From BBB-razil to BB+razil or the meaning of investment grade

Matias Vernengo

So Brazil (or here about Petrobras, the State oil company) lost its investment grade status with Standard & Poor’s. You would think this is huge given the media attention in Brazil. If you read S&P’s actual rationale for the downgrading (here) it is essentially about the fiscal situation. They say: “We now expect the general government deficit to rise to an average of 8% of GDP in 2015 and 2016 before declining to 5.9% in 2017, versus 6.1% in 2014. We do not expect a primary fiscal surplus in 2015 or 2016.” They do discuss the political problems too, the corruption investigations,* and the political instability that has plagued the government. There is a discussion of the external vulnerability, but here they are quite sensible and know there is no problem. The report says that: “despite the wider current account deficit, Brazil has low external financing needs compared with its current account receipts and its high level of international reserves compared with some of its peers.” So this is a fiscal problem in their view.

And therein lies the problem. They had years ago also revised the outlook of US debt negatively (my comments here), also on the basis of fiscal, and political, factors. As much as the US then, Brazil now has no risk of not paying its internal debt in domestic currency. And yes, the fiscal outlook has worsened, and the reasons are no secret. It’s austerity. If you cut spending, output falls, and the recession leads to lower revenue and higher deficits. It’s part of the problems caused by policies that S&P’s analysts actually favor. Austerity also is the cause of the recession, and the worsening of the growth outlook in the next couple of years, which are also discussed in S&P’s rationale for the downgrade. So the fiscal problems that are the main cause for the downgrade are self-inflicted wounds (see Serrano and Summa), and the cause of the lack of growth and the worsening of the future fiscal balances.

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New Food for the Vultures?

Lack of state insolvency regime undermines Ukraine debt deal

By Bodo Ellmers, Guest Blogger

Bodo Ellmers is Policy and Advocacy Manager at Eurodad, the European Network on Debt and Development.

Ukraine has reached a debt restructuring agreement with a creditor committee representing 50% of outstanding government bonds. Substantial debt reduction is essential to bring Ukraine’s debt down to sustainable levels. But the agreed deal falls short of what is needed. And the participation of the other 50% of bondholders is not secured, and cannot be secured in absence of a multilateral debt restructuring framework that can make binding and enforceable decisions. The Western powers’ reluctance to help build such a framework might have fed their ally to the vulture funds and their aggressive litigation strategies.

The Ukraine debt deal

According to information obtained by the Financial Times, Ukraine has reached a deal with a creditor committee led by the investment fund Franklin Templeton. The deal agrees a 20% haircut to Ukrainian government bonds worth US$18bn. It will also extend the repayment period by four years to ease Ukraine’s liquidity needs. As a sweetener, participating creditors receive a higher interest rate of 7.75% instead of 7.2%. In addition, reports the FT, “a GDP ­linked warrant will be provided from 2021 to 2040 that will pay out up to 40 per cent of the value of annual economic growth above 4 per cent.”

Too little, too late

The deal comes after Ukraine’s economy fell into a deep recession following the outbreak of the civil war and the annexation of the Crimean peninsula by neighboring Russia. Last year, Western powers used their influence in the IMF to unleash bailout loans of €9.6bn under the Extended Fund Facility. The programme came with brutal austerity and structural adjustment conditionality attached.

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The Failed Project of Europe

Jayati Ghosh

There is a stereotypical image of an abusive husband, who batters his wife and then beats her even more mercilessly if she dares to protest. It is self-evident that such violent behaviour reflects a failed relationship, one that is unlikely to be resolved through superficial bandaging of wounds. And it is usually stomach-churningly hard to watch such bullies in action, or even read about them.

Much of the world has been watching the negotiations in Europe over the fate of Greece in the eurozone with the same sickening sense of horror and disbelief, as leaders of Germany and some other countries behave in similar fashion.

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The Greeks Have Said No to Failed Policies, Not to Europe or the Euro

Matias Vernengo

Originally published by The Wire.

The referendum that just took place in Greece in which 61.3% of voters rejected the terms of an international ‘bailout’ package should not be read as a vote in favour of leaving the euro. The ‘No’ vote – όχι in Greek – is, as correctly pointed out by James K. Galbraith, the only hope for Europe. On the other hand, it may very well be used by the Troika – the European Union (EU), the European Central Bank (ECB), and the International Monetary Fund (IMF) – as an instrument for expelling Greece from the monetary union. If that happens, we have a Grexpulsion and not a Grexit, the more common name for the abandonment of the euro. After all, it is very clear that SYRIZA knows that the costs of leaving the euro may very well outweigh the advantages, and that Greece is not Argentina, as noted by its Finance Minister Yanis Varoufakis recently.

The relationship between West European powers and the Greek Left has been problematic for a long while. In the aftermath of World War II, the British and then the Americans, sided with collaborationists, rather than with the resistance, which had communist leanings, and was seen potentially allied to the Soviets. As Tony Judt says of Greece in Postwar: A History of Europe Since 1945, “despite a significant level of wartime collaboration among the bureaucratic and business elites, post-war purges were directed not at the Right but the Left. This was a unique case but a revealing one.” The British and Americans preferred a conservative government, even if it meant dealing with businessmen who had collaborated with Fascists, rather deal with a communist or socialist threat.

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A Way Out for Greece and Europe

Keynes’ Advice from the 1940s

Marie Christine Duggan, Guest Blogger

Marie Christine Duggan is a professor of economics at Keene State College in New Hampshire. In this article, originally published in the May/June 2015 issue of Dollars & Sense magazine, she argues that the kinds of system proposed by Keynes for adjustment to international imbalances in the 1940s would represent a way out of crisis for Greece and Europe today.

Is there a way for Greece to honor its debts without impoverishing its people? Most people see only two ways out of the current crisis: Either Greece services its debts, and the wealth gap between creditor and debtor nations in Europe rises; or Greece defaults, and the European banking system is forced to write-down its assets by the value of the Greek IOUs. However, there is a third way: creditors could promise to spend the money they receive from Greece (in the form of debt service payments) on Greek imports or on long-term for-profit investments in Greece. This third way involves re-aligning institutional incentives so that the creditors only gain when the debtors themselves grow.

Problems like those Greece faces are not new. And, in fact, the best solutions are not new either. During the Second World War, Britain faced a similar situation of trade deficits coupled with a cut-off of international credit. John Maynard Keynes devised a solution which did not impose all the burdens on the debtors by reducing wages. Instead, it would not be just debtor countries—but also creditor countries—that would have to “adjust.” The creditors would have to spend their surpluses (rather than building up reserves), allowing the debtors, in turn, to grow their economies and pay back their debts. Dependence on the fickle whim of the foreign investor is the story line that unites the post-war British context with that of Greece today. In another similarity, the subtext for Greece, since it joined the eurozone in 2001, has been the need to increase its productive capacity and infrastructure so that its products—priced in euros—are produced efficiently enough to compete with those from other eurozone countries. A solution like the one Keynes proposed for Britain towards the end of the war would offer Greece the best way out today.

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