Thursday 19 Jul 2018 | 00:59 | SYDNEY
Thursday 19 Jul 2018 | 00:59 | SYDNEY

Stimulus and sustainability


Mark Thirlwell

4 June 2010 08:24

I argued yesterday that there are sound reasons for policymakers in the developed world to deliver fiscal consolidation over the medium term. But there's a big risk: move too soon and the negative consequences for the recovery are likely to be large and painful (and indeed will deliver yet more fiscal deterioration in the near-term).

Fiscal adjustment optimists might argue that this need not be the case. They can point to a literature on the non-Keynesian effects of fiscal tightening which, drawing on some European examples from the 1980s and early 1990s, argues that fiscal consolidation can actually be expansionary. 

So, for example, a fiscal contraction can lead to lower real interest rates, which can stimulate demand. And if the adjustment is seen as heading off a looming financial crisis, this has the potential to further revive confidence and hence boost investment and consumption. 

Such a recommendation does make sense for a country facing fiscal crisis. But for an economy like the UK and even more so for the US, the upbeat part of this story does not appear particularly persuasive right now: a quick look at long-term government real interest rates fails to suggest that markets are overly concerned about US debt sustainability, for example, and hence that a big fiscal effort would deliver the offsetting stimulus of sharply lower real rates. At best, it can prevent a potential future rise in rates.

All of which leaves many developed country policymakers stuck somewhere between a rock and a hard place. 

On the one hand, they face a growing chorus of voices calling for serious efforts to deliver fiscal consolidation, and to do so as soon as possible. There is also the implicit threat that if they fail to do so, markets might suddenly stop being sanguine about their debt positions and start bidding up interest rates, á la Greece. On the other hand, these policymakers still have to manage weak and fragile economies that, all else equal, would argue for expansionary, not contractionary, macro policies.  

The sensible policy response would seem to be pretty straightforward: to continue with stimulatory policies for now while simultaneously putting in place a credible and binding program for medium term fiscal retrenchment. This could still work. 

The problem is that it's often quite difficult for governments to make credible commitments in this way. That's one reason for the calls for (premature) adjustment. These calls may well sound perverse: as Martin Wolf puts it, they amount to the proposition, 'If you are unwilling to starve yourself when desperately ill, nobody will believe you would adopt a sensible diet when well.' Nevertheless, the calls are growing louder.

Photo by Flickr user blmurch, used under a Creative Commons license.