Expansionary Austerity?

by: Shareholders Unite

Some, especially in Europe, argue that cutting public expenditures would boost the economy. Do they have a point?

We'll start with some of the objections that have been raised against those who argue for the need for the public sector to stimulate the economy, as there has been more debate on this and it's simply the mirror image.

It is noteworthy that these mainly come from so-called freshwater economists. These are economists that have a strong belief in the self-healing (or 'equilibrium' restoring) properties of markets, which is the main reason they are somewhat allergic to state intervention.

However, if markets have a strong tendency to move back towards equilibrium fairly fast, the onus is on them to explain how an economy can be stuck in an underemployment equilibrium for extended periods of time. So what are the reasons for thinking that a stimulus wouldn't work?

Crowding out

Some argue that increased public spending replaces private spending through an increased claim on the savings pool. There are several versions of this argument. Some, like Eugene Fama and John Cochran, argue that because in equilibrium, savings equal investments, an increase in debt financed public spending diminishes the savings pool and hence private investment simply has to fall.

However, they simply mistake an accounting identity for a behavioral relationship. For instance, higher public borrowing can increase interest rates which reduces private investment. However, they seem completely oblivious to the fact that savings and investments can be equated by more than just the interest rate.

If the debt financed public spending increases output (and we have strong indications that it does), and hence income, it will also increase savings as these are a function of income.

Not only that, the rise in interest rates hasn't materialized at all (rather the contrary) even in the face of record public deficits and debt levels, completely miffing people like Fama and Cochrane. This isn't as mysterious as it might seem. If we are in a balance sheet recession, savings are aplenty. In fact, according to the IMF there is a world savings glut that is only set to increase:

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This isn't really a surprise, it's just the flip side of a lack of aggregate demand, mostly due to households repairing balance sheets (or being unemployed, or seeing wages decline). Crowding out is simply much less likely in an economy which has a lot of unused resources. If the public sector mobilizes some of these into productive use, income and savings increase as well.

Ricardian equivalence

Ricardian equivalence is a theorem that argues that increased deficit spending will be offset by a reduction of private spending because economic agents 'know' that taxes will have to go up in the future. This has always struck us as a rather curious piece of economics, although it follows logical from models in which agents are fully rational, markets instantly clear and capital markets are perfect (amongst others).

The only problem with that is that we know the real world isn't anything like that. Here is a pretty unkind take-down of the concept by creditwritedowns. Krugman has argued that even if one beliefs in Ricardian equivalence, it doesn't mean that fiscal policy won't work, according to him:

It’s one thing to have an argument about whether consumers are perfectly rational and have perfect access to the capital markets; it’s another to have the big advocates of all that perfection not understand the implications of their own model.

He goes on explaining why:

Here’s what we agree on: if consumers have perfect foresight, live forever, have perfect access to capital markets, etc., then they will take into account the expected future burden of taxes to pay for government spending. If the government introduces a new program that will spend $100 billion a year forever, then taxes must ultimately go up by the present-value equivalent of $100 billion forever. Assume that consumers want to reduce consumption by the same amount every year to offset this tax burden; then consumer spending will fall by $100 billion per year to compensate, wiping out any expansionary effect of the government spending.

But suppose that the increase in government spending is temporary, not permanent — that it will increase spending by $100 billion per year for only 1 or 2 years, not forever. This clearly implies a lower future tax burden than $100 billion a year forever, and therefore implies a fall in consumer spending of less than $100 billion per year. So the spending program IS expansionary in this case, EVEN IF you have full Ricardian equivalence.

Expansionary austerity?

Some people propose the idea that austerity (the opposite of stimulus) would increase 'confidence' so much it would have an expansionary effect in the economy (that is, the reduction in public spending would be more than offset by an increase in private spending). Here is Martin Wolf from the FT:

A reduction in the fiscal deficit must be offset by shifts in the private and foreign balances. If fiscal contraction is to be expansionary, net exports must increase and private spending must rise, or private savings [must] fall. [Martin Wolf]

How can that happen? Well, if there is a large fall in the exchange rate, net exports would rise. If there is a large fall in interest rates, private investment would rise. Krugman:

So every one of these stories says that you can have fiscal contraction without depressing the economy IF the depressing effects are offset by huge moves into trade surplus and/or sharp declines in interest rates. Since the world as a whole can't move into surplus, and since major economies already have very low interest rates, none of this is relevant to our current situation. [Krugman]

Here are some examples from supposedly successful episodes of fiscal retraction:

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You see that these have been successful only if the private sector leveraged up (that is, took on more debt). Since the situation today is that the private sector is already over leveraged, we're not sure this is the way (or indeed feasible).

Indeed, the whole idea of the stimulus came about by recognizing that the private sector needs to de-leverage and the resulting fall in demand needs to be compensated if this isn't going to led to a severe slump.

The one exception is Ireland in the late 1980s, which is the poster child of expansionary austerity. But the way it worked was that interest rates came down pretty hard.


Keynesians who believe in stimulus spending (and/or tax cuts) point out that in a depressed economy, building a bridge, a road or employing teachers, will lead to a ripple effect in the economy as the construction workers and teachers get income which they're going to spend, which creates further income, which is spend, etc.

So apart from having bridges and teachers teaching, reinforcing the supply side of the economy, there is something of a ripple effect through the economy. The ultimate expansion of production and income is larger than the original debt financed public spending, we have a multiplier larger than one.

Robert J. Barro, the (re)inventor of the Ricardian equivalence theorem and notable freshwater economist, has called this Voodoo economics. His argument is that military spending was higher than GDP growth (only just), which points to a multiplier smaller than one. Krugman has not taken kindly to this argument:

Actually, I’ve already taken that one on. But just to say it again: there was a war on. Consumer goods were rationed; people were urged to restrain their spending to make resources available for the war effort. Oh, and the economy was at full employment — and then some.

Under full employment the multiplier is likely to be much lower as there are simply no scarce resources and a demand stimulus is much more likely to lead to bidding the prices up of resources, rather than to increase production and income.


The best argument against additional stimulus spending is the level of debt. Although the popular argument that one cannot solve a debt problem by issuing more debt isn't necessarily correct, we think. In a balance sheet recession, households pay down debt, save more, and spend less.

This is rational for the individual, but collectively this can produce a self-reinforcing fall in demand known as the 'paradox of thrift.' We have seen in the 1930s what such a fall can achieve, and we've shown here how a similar steep fall in 2008-9 was arrested by rather strong policy reaction. This could ultimately trigger a debt-deflationary cycle which is a terrifying prospect in which the real value of debt rises because of deflation (a mechanism first identified by Irving Fisher in the 1930s, here is an excellent rendition by Steve Keen).

Well, since the public sector can borrow for essentially zero real rates (five year yields are actually below inflation), one could argue that there must be projects which generate a positive return, improving both the economic structure and making up for the shortfall in demand from households while these repair their balance sheets.

Investments in R&D, education, infrastructure generally are recognized to generate a significant positive return. However, deficit hawks would argue that we can't count on interest rates being so low forever, and they have a point. Often fingers are pointed at euro zone countries, but that isn't quite right, because there are wholly different dynamics at work there.

The euro zone countries now under attack are suffering from a lack of competitiveness (which they can't repair by devaluing their currency because they don't have a national currency) and, even more important, they effectively borrow in a currency over which they have no control, depriving them of a lender of last resort in the form of having their own central bank. Investors have, after talks of Greek 'haircuts', woken up to that fact and started running for the exit.

The US is fundamentally different. It basically cannot go broke as it's debt is in US dollars, the supply of which is under full control of the US. So far, despite numerous false calls (from the WSJ editorial and Neill Fergusson, amongst many) rates have only gone down further and this can go on for quite some time as there is a world savings glut and US Treasuries do not have a lot of competition in the safe asset class department right now.

One can also say that a couple of years of stimulus spending doesn't make much of a difference for the long-term public debt sustainability, structural developments like rising health cost are much more important for that.

Consider the long-run budget implications for the United States of spending $1 trillion on stimulus at a time when the economy is suffering from severe unemployment. That sounds like a lot of money. But the US Treasury can currently issue long-term inflation-protected securities at an interest rate of 1.75%. So the long-term cost of servicing an extra trillion dollars of borrowing is $17.5 billion, or around 0.13 percent of GDP. And bear in mind that additional stimulus would lead to at least a somewhat stronger economy, and hence higher revenues. Almost surely, the true budget cost of $1 trillion in stimulus would be less than one-tenth of one percent of GDP. [Krugman]

Even at its height, the stimulus wasn't even the biggest contributor to the deficit, as the bad economy is a bigger force

IMF assesses that from a total of 35.5% increase of public debt as a % of GDP in the years 2007-14, only 3.5% comes from stimulus. [Krugman]

But still. Public debt is approaching levels which makes people uncomfortable (we are no exception, as it happens), and this is understandable. One cannot guarantee that interest rates will always be this low (although when they won't, it most likely because the economy has recovered).

A good compromise would be to do a short-run stimulus while at the same time addressing the long-run structural drivers of public deficits and debts. And one could also consider the following factoid from econbrowser:

federal tax revenues last year were 14.9 percent of GDP, their lowest level in the past 60 years. Not only have tax revenues been growing less slowly than the economy, they are substantially lower than taxes in most other developed nations. ...

After all, there are some reasons why public expenditures tend to rise when countries become richer (which warrant a separate article). There is some room for some tax increases without the US becoming a European welfare state (even if there are quite a few successful ones) and losing its distinctive character.


The US isn't Greece, it cannot go bankrupt and a few years of stimulus spending, even a big stimulus, wouldn't matter a whole lot for the long-term sustainability of public finances. However, deficits and debts are already high in the US.

Although interest rates will not rise significantly any time soon as long as the economy remains depressed and as long as there is a world savings glut, one cannot rely on interest rates remaining this low forever. This is why credible plans have to be developed to tackle the long-term structural drivers of the public deficits and debts, like healthcare cost.

The claim that austerity is expansionary doesn't have much support from the facts, and is mainly made by economist who come from a more theoretical world in which markets clear quickly but recessions cannot really exist for any prolonged period of time. One can, therefore, have serious doubts about the reality of these models.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.