The United States has yet to resolve its “fiscal cliff”, its own version of austerity. Dimitri B. Papadimitriou and Greg Hannsgen of the Levy Economics Institute offer an analysis of what they term the “fiscal trap.” They argue many economists and policymakers continue to misunderstand the role of fiscal policy, especially in times of economic turmoil, and have, as a result, failed to offer effective policies to repair the economies of the US and eurozone

Hannsgen, Greg

Papadimitriou, Dimitri B.

English

LSE Research Online

blo gs.lse.ac.uk http://blogs.lse.ac.uk/europpblog/2012/12/07/europe-fiscal-trap/Europe is now stuck in a fiscal trap, brought about by thefailure of orthodox economics to provide an effectivestrategy for economic growth.by Blog AdminThe United States has yet to resolve its “fiscal cliff”, its own version of austerity.  Dimitri B.Papadimitriou and Greg Hannsgen of the Levy Economics Institute offer an analysis ofwhat they term the “fiscal trap.” They argue many economists and policymakers continue tomisunderstand the role of fiscal policy, especially in times of economic turmoil, and have, asa result, failed to offer effective policies to repair the economies of the US and eurozone. Why would US policymakers contemplate f ollowing Europe’s f ailed austerity policies byimposing spending cuts and tax increases that are widely expected to push the USeconomy back into a recession? Why would EU countries continue austerity policies thathave not brought economic recovery? To address these questions, we present a modelof  what we call the “f iscal trap”: a self - imposed spiral of  economic contraction resultingf rom a f undamental misunderstanding of  the role and f unction of  f iscal policy in t imes ofeconomic weakness.The results of  austerity policies in the UK and in much of  the eurozone have beendisastrous. The “f iscal crisis” began when Greece, Ireland, and Portugal approached def ault in 2010, andthis specter of  def ault gave rise to the f iscal austerity policies instituted across the eurozone. Since2010, f iscal policy has tightened drastically throughout Europe. Unemployment in the eurozone hasreached record levels. Today, Europe is f eeling the ef f ects of  a self -def eating cycle of  t ight f iscalpolicies and low growth rates. We call this cycle of  f iscal reduction and economic contraction a “f iscaltrap”.The basic trap is a cycle that moves f rom a decline in demand to f alling tax revenues, which in turnengenders spending cuts and tax increases. Spending cuts and tax increases undercut the economyf urther, and the cycle continues. The basic trap is illustrated by the f our dark arrows at the top andcentre of  Figure 1. (All arrows in the f igures show directions in which causality exerts itself .)The upper pair of  dark arrows in thef igure illustrates “f iscal drag”. In thecontext of  mainstream US Keynesianpolicymaking, f iscal drag ref ers to theperverse tendency (f rom theperspective of  good countercyclicalpolicy) of  governments to engage inpro-cyclical f iscal policy, due to legalrequirements or polit ical pressure to tryto achieve balanced budgets. Such ill-t imed spending cuts and tax increasesinclude most of  the austerity measuresadopted recently in countries aroundthe world.The downward pressure on f iscalstimulus exerted by an aversion todef icits is shown in Figure 1 in themovement f rom rising def icits tospending cuts and increased taxes. The ef f ects of  such reductions include slow growth, risingunemployment, declining aggregate demand, and f alling prof its. Moreover, f iscal austerity can be self -def eating, as shown by the lower pair of  dark arrows. Low or negative growth f eeds back into the viciouscycle of  the f iscal trap by reducing government tax revenues, raising expenditures on transf erprogrammes, and hence increasing f iscal stress, completing the basic trap. The dynamics of  the basicf iscal trap highlight the need f or temporary stimulus packages in t imes of  negative or slow growth. Theyalso underscore the value of  permanent “automatic stabilisers” such as means-tested benef its and aprogressive tax code.The f ull f iscal trap includes the f orces illustrated by the light-coloured arrows in Figure 1. These arrowsdescribe the part of  the trap that owes its existence to a f aulty currency system, such as the euro, orany other “sound money” system, including a gold-backed currency. The question of  how to escape thef iscal trap is broadly answered by two competing perspectives: metallism and chartalism.While well known to macroeconomists, other readers may appreciate a clarif ication of  the terms. The“metallist” approach to solvency views the money supply as constrained by some outside condition.Money is based on something that has a limited supply, either because it is based on something physical(again, such as gold) or because of  some constraint on the government’s ability to issue liabilit ies. Incontrast, chartalists do not see the money supply as intrinsically constrained. This f reedom allows f iscalpolicy to be guided only by an imperative to maintain f ull employment – without, of  course, spurringexcessive inf lation. Hence, the chartalist perspective regards solvency as a non- issue f or governmentsthat possess a sovereign currency, with the understanding that they must permit their exchange rates tovary f reely. These two perspectives def ine very dif f erent approaches to economic recovery.In our interpretation of  the European f iscal trap, the eurozone’s metallist monetary institutions play acrucial role, turning a basic trap into a f ull trap. Some of  the more orthodox voices – f or example, theCongressional Budget Of f ice, the International Monetary Fund  and the New York Times – haveunderestimated or ignored the special handicap f aced by national governments that are f orced tooperate with one hand tied behind their back; namely, these governments lack the power to create “statemoney.” In other words, eurozone metallists and like-minded orthodox commentators imagine that thecomplete analysis shown in Figure 1 is equally applicable to all nations with sovereign debt, including“sovereign currency” countries such as Canada, Japan, the United States, and the UK. But it is not.Central banks in countries with sovereign currencies and f lexible exchange rates use open marketoperations to keep short- term interest rates stable, and can even, given enough time, consistently hit atarget f or long-term yields, even when they are running up large debts. For example, the US FederalReserve ef f ectively set rates on longer-term Treasury debt during the late 1940s and early 1950s. Morerecently, the Fed’s strategy to keep long-term rates low has led to record- low average home mortgageinterest rates, albeit under t ightened lending standards. Figure 2 highlights the way that such central bankoperations ensure that governments in sovereign-currency nations can “escape” the f ull- trap mechanism.The cycle of  the f ull f iscal trap is broken when the government makes its own means of  payment. This isboth a prudent and a proven system, but its distinctive workings are sometimes f orgotten in t imes ofeconomic turmoil. On the other hand, the basic trap illustrated by the dark-coloured arrows alone canpresent a serious problem in cases such as those of  the UK and the United States: interest rates remainvery low, and capital markets remain conf ident in the solvency of  the central governments involved, butjob creation and demand f or private-sector output are f ar too weak.Orthodox economics, the sameperspective that helped to bring us thef inancial crisis and the Great Recessionof  2007–09, has f ailed to provide anef f ective strategy f or economic growth.This perspective has steered theeurozone into a self - imposed f iscal trapand may convince policymakers inWashington to do the same. We arguef or another approach. The renewedvigour seen in many heterodoxeconomic tradit ions of f ers a betterhope f or ef f ective policies that will helpcountries steer clear of  the f iscal trapand put their economies back on a pathto recovery.This article is based on the LevyEconomics Institute of Bard CollegePublic Policy Brief, “Fiscal Traps andMacro Policy after the Eurozone Crisis”.Note:  This article gives the views of the authors, and not the position of EUROPP – European Politics andPolicy, nor of the London School of Economics.Shortened URL for this post: http://bit .ly/SQ9YzV _________________________________About the authors Greg Hannsgen – Levy Economics InstituteResearch Scholar Greg Hannsgen is a macroeconomist and monetary economist, and amember of  the research team behind the Institute’s Strategic Analysis series. Hannsgen’sresearch interests include monetary and f iscal policy issues in the United States andabroad; heavy-tailed distributions in macroeconomic data and modeling; money, f inance,and the business cycle; Keynesian and post-Keynesian macroeconomics; and normativeand social aspects of  macroeconomic analysis.Dimitri B. Papadimitriou – President, Levy Economics InstituteDimitri B. Papadimitriou is president of  the Levy Institute and executive vice president andJerome Levy Prof essor of  Economics at Bard College. His areas of  research includef inancial structure ref orm, f iscal and monetary policy, community development banking,employment policy, and the distribution of  income and wealth. He also heads theInstitute’s Macro-Modeling Team, which is responsible f or the Strategic Analysis reportseries. Papadimitriou is a past vice-chairman of  the Trade Def icit Review Commission andserved on the Competit iveness Policy Council’s Subcouncil on Capital Allocation.Related posts:1. Proposals f or a European Banking Union must be redesigned to provide a more accountable andef f ective institutional f ramework. (10.5)2. Reducing Catalonia’s autonomy as a reaction to the f iscal crisis would only provide more f uel f orsecession-minded nationalists (10.4)3. Europe’s prosperity is not to be built via polit ical declarations and never-ending summits.Promoting f ree, f air and open international trade and removing the remaining barriers to anef f ective single market in Europe are key f or f uture growth (10.7)

Europe is now stuck in a fiscal trap, brought about by the failure of orthodox economics to provide an effective strategy for economic growth

Abstract

Similar works

Full text

Available Versions

LSE Research Online