SWITZERLAND—Europe’s intractable sovereign debt crisis engulfed Italy with surprising speed last week, forcing the adoption of $56 billion in austerity measures that are projected to bring the country’s budget into balance in 2014.
Once again, European leaders are working to contain the crisis, which has only now spilled over from the peripheral economies to one of the Continent’s largest.
The stakes are high. If the potential for contagion is fully realized in Europe, the resulting disruptions will threaten another global recession. As for the means to the end, bond markets are seeking deep spending cuts rather than substantial increases in taxes. The economic literature suggests that closing the budget gap can be expansionary, sometimes even in the short-run.
There are lessons therein for the United States, where the looming threat of default forewarns an even more perilous upending of world economic and geopolitical stability.
In Italy, as Here, a Political Dimension
Writing over the weekend from my hotel near the Swiss-Italian border, the immediacy of the latter’s predicament seems to have abated for the time being. Last Thursday, its Treasury successfully auctioned $5 billion in government bonds, albeit at sharply higher spreads than just a month earlier. The oversubscription of the bond sales is a fleeting comfort for Europe’s leaders.
The vagaries of the market mean that a sense of crisis—in Italy or elsewhere in the euro zone—will reassert itself vigorously if the region’s broader dilemma is met with further indecisiveness.
It was not assured that markets would turn on Italy until yields actually spiked. As Alan Auerbach describes in a paper prepared for the Bank of International Settlements conference here in Lucerne just a few weeks ago, “Debt-GDP ratios alone typically do not tell us how long countries have before they must make fiscal adjustments or how large these adjustments need to be” [i].
Rather than a pure economic driver, Rome’s dysfunctional political environment served as the immediate trigger for Italy’s current slide into disfavor. In particular, Prime Minister Silvio Berlusconi’s recent muddying of budgetary politics cast into doubt his commitment to fiscal discipline, prompting last week’s backlash from bond markets.
Mr. Auerbach proves himself prescient, writing that, “Fiscal projections aside, a country’s political environment and fiscal institutions matter, too, for they provide a reading of the ease or difficulty with which needed adjustments can occur” [ii].
Politics Aside, a Real Problem
Apart from the political theater, Italy faces very real challenges. In spite of a primary balance surplus (a budget surplus before interest payments), the government is deeply indebted, to the tune of 120 percent of gross domestic product.
That presents a serious challenge in light of Italy’s lackluster historical and projected growth trends. Servicing its legacy debt obligations is sufficiently onerous that its overall obligations continue to rise. Mr. Auerbach describes three sources of fiscal imbalances: cyclical, as tends to be observed during recessions; structural, implying a deficit that persists even after the economy has returned to health; and those related to current or future pension and health spending. In Italy, at least two of these are relevant, made larger by the slow growth in economic output.
The need for structural adjustments in the Italian budget might be taken in stride but for current optics. The debt burdens of the major economies are under close scrutiny. Thus far, the euro zone has shown itself regrettably plodding in dealing with the crisis along its periphery.
Differences of ideology, incentives and opinion about who should bear the cost of restructuring and whether to take the significant step of authorizing eurobonds separate the weaker economies from Europe’s core and have precluded durable solutions when they would have been most efficacious. The result of inaction has been a decline in market confidence regarding the position of the peripheral economies and their stronger counterparts, as well.
The partial solutions adopted for Greece, in particular, have left open the potential for contagion. Recent events suggest that that potential is being realized. And whereas the euro zone’s resources, coupled with those of the International Monetary Fund, can meet the demands of crises in the smallest economies, the scale of Italy’s sovereign bond market dwarfs the capacity of the European Financial Stability Facility. The largest sovereign market in Europe and the third largest globally, Italy has $2.6 trillion in debt outstanding, in the range of 10 times the stability funds committed and still available.
Can Austerity Be Expansionary?
In an effort to avoid a default in Europe, a given country’s debt might be restructured, with banks or other private-sector parties holding exposures bearing the costs that are not borne by governments. As a complement or alternative, countries enjoying continued access to credit markets might directly or indirectly extend lines of credit to their constrained peers. In many respects, a Eurobond market is little more than a formalization of such an arrangement.
In any case, lenders and investors will typically demand serious concessions of defaulters that are favorable to long-term fiscal sustainability. For a country like Greece, that means a combination of revenue programs and spending cuts. In part, because of where the relative burden of these two options falls, the fiscal adjustment takes on a socioeconomic dimension that plays out in politics and the streets.
The United States is not so different from Greece in this regard. At the heart of the domestic budget debate here is the question of whether to increase taxes, a burden that is perceived as falling disproportionately on high-income households, or curtailing expenditures on programs that benefit a wider cross-section of Americans. The polarization of the public discourse and the portrayal of these options as mutually exclusive are unfortunate. Nothing in the economic analysis requires that we act with opprobrium.
We do not expect that our elected officials will agree on matters of ideological and political significance. On the contrary, the short-term incentives to which they are most sensitive push them very hard to disagree. We do, however, expect the parties’ leadership to find common ground on issues that are vital to the national interests. As of the time of this writing, however, no budget deal had been reached. A resolution at the 11th hour deserves no self-congratulation given the stalemate’s drag on economic activity. As with European hesitation, brinksmanship at home has undercut confidence in our political system and our economy, jeopardizing our recovery.
Apart from the complex political calculus of necessary entitlement reform, policymakers are reasonably concerned with the impact of any contraction on fiscal consolidation. The elementary Keynesian analysis is straightforward: a drop in government expenditures will reduce GDP growth.
The reality is more nuanced and depends upon expectations about future public expenditures. The bulk of the economic literature shows that narrowing budget deficits are generally expansionary. Although their results are qualified by more recent research, Alberto Alesina and Silvia Ardagna show that cutbacks in public spending can be associated with increases in private consumption [iii]. Of course, that will not always be the case. On a systematic level, the literature may also overstate the expansionary effect of austerity.
In a just-released working paper from the International Monetary Fund, Jaime Guajardo and his colleagues find that “the standard method used to identify fiscal consolidation in the literature may bias the analysis toward finding support for the expansionary austerity hypothesis” [iv]. This is an important qualifier that I must concede in fairness to the analysis.
Balancing Mr. Guajardo’s findings, a new research paper from the European Central Bank again demonstrates the confidence channel whereby “fiscal shocks that are followed by an expected future reversal in spending have a positive effect on output, private consumption, and investment” [v].
I would postulate that, controlling for the fiscal shock, private investment and consumption respond positively to businesses’ and consumers’ expectations of improving fiscal discipline. Further, that expectation is better served by a contraction in public spending than an increase in taxes since the latter suggests a weaker commitment to containing public expenditure growth. If that is the case, our choices in balancing spending cuts and tax increases should signal a commitment to long-term fiscal discipline by incorporating credible and permanent reductions in expenditures.
The more effective the signal that results, the stronger the outlook will be for the American economy.
dsc@chandan.com
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School.
[i] Alan Auerbach: Long-Term Fiscal Sustainability in Major Economies. Prepared for the Tenth Annual Bank of International Settlements Annual Conference, Lucerne, Switzerland, June 2011.
[ii] Ibid.
[iii] Alberto Alesina and Silvia Ardagna: Large Changes in Fiscal Policy: Taxes Versus Spending, Tax Policy and the Economy. Edited by Jeffrey Brown. National Bureau of Economic Research, 2010.
[iv] Jaime Guajardo, Daniel Leigh and Andrea Pescatori: Expansionary Austerity: New International Evidence. International Monetary Fund Working Paper WP-11-158.[v] Jacopo Cimadomo, Sebastien Hauptmeier and Sergio Sola: Identifying the Effects of Government Spending Shocks With and Without Expected Reversal. European Central Bank Working Paper Series, No. 1361, July 2011.
