20 February 2012

VoxEU: Has austerity gone too far?

Authors Giancarlo Corsetti and Gernot Müller write that the root of the problem is the “sovereign-risk channel”, that is, the tendency of sovereign risk to affect borrowing conditions in the broader economy adversely. It has three implications:

Fiscal multipliers are lower than usual if sovereign risk is high: The presence of a sovereign-risk channel changes the transmission of fiscal and monetary policy, particularly so when the latter is constrained (because, for example, policy rates are at the zero lower bound, or because the economy operates under fixed exchange rates). When sovereign risk is high, a given change in government spending causes a smaller change in output than in normal times. The reason is the offsetting impact from sovereign risk premia, which in our model respond to the health of public finances. Under extreme conditions, the multiplier could even turn negative. Typically, however, consolidations will be contractionary in the short run. Yet, self-defeating consolidations are also unlikely, as multipliers are generally small.

Procyclical fiscal policy may help to ensure macro-economic stability: Due to the sovereign-risk channel, highly-indebted economies become vulnerable to self-fulfilling economic fluctuations. In particular, an anticipated fall in output generates expectations of a deteriorating fiscal budget, causing markets to charge a higher risk premium on government debt. Through the sovereign-risk channel, this tends to raise private borrowing costs, depressing output and thus validating the initial pessimistic expectation.

Under such conditions, a procyclical cut in public spending can stem the possibility of a confidence crisis, by limiting the anticipated deterioration of the budget associated with output contractions. This suggests that highly indebted countries may be well-advised to tighten fiscal policies early, even if the beneficial effect of such action – prevention of a damaging crisis of confidence – will naturally be unobservable. From a probabilistic perspective, even a relatively unlikely negative outcome may be worth buying insurance against if its consequences are sufficiently momentous.

Beyond austerity: To be sure, the near-term output costs of fiscal austerity make it worthwhile to keep thinking about alternative strategies. One such example is making commitments to future tightening more credible, for instance, through legislation on entitlement programs with long-term consequences for the fiscal deficit.

The authors' work on the sovereign-risk channel also suggests focusing on ways to limit the transmission of sovereign risk into private-sector borrowing conditions. Strongly capitalised banks are one key element in this regard. The ongoing efforts, coordinated by the European Banking Authority, to create extra capital buffers in European banks correspond to this logic. Another element is the attempt by monetary policymakers to offset higher sovereign risk premia. Normally, the scope to do this is exhausted when the policy rate hits the lower bound. Recent unconventional steps by the ECB, however, suggest that more is possible. The extension of three-year loans to banks, in particular, appears to have reduced funding strains, with positive knock-on effects for government bond markets.

Conclusion

In sum, weak growth in countries facing precarious fiscal positions is not sufficient evidence against fiscal austerity. Where sovereign risk is high, fiscal tightening remains an important avenue to bring down deficits at a limited cost to economic activity, as risk premia recede over time. In addition, fiscal austerity may well have important unobserved benefits, by preventing greater macro-economic instability which tends to arise in the presence of high sovereign risk. That said, the authors' analysis also suggests that policymakers should explore other ways to contain sovereign risk premia, or at least reduce their impact on broader economic conditions.

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