Home > Fiscal Policy, Growth, sovereign debt > It’s the Denominator, Stupid!

It’s the Denominator, Stupid!

February 25, 2013 Leave a comment Go to comments

This weekend’s news was the downgrade of the UK by Moody’s. Chancellor Osborne took this as a sign that austerity should be strengthened even more, probably because he had little choice (never put all your eggs in one basket…). And yet, if only somebody in Downing Street bothered going through the text, they would have read this:

The key interrelated drivers of today’s action are:
1. The continuing weakness in the UK’s medium-term growth outlook, with a period of sluggish growth which Moody’s now expects will extend into the second half of the decade;
2. The challenges that subdued medium-term growth prospects pose to the government’s fiscal consolidation programme, which will now extend well into the next parliament;
3. And, as a consequence of the UK’s high and rising debt burden, a deterioration in the shock-absorption capacity of the government’s balance sheet, which is unlikely to reverse before 2016.

Thus, Moody’s analysts clearly state the direction of causality: sluggish growth jeopardizes fiscal consolidation. They do not say it explicitly, but it is hard not to conclude that sustainability of public finances is therefore best served through growth than through austerity.

This is almost common knowledge by now. Even among “market participants”, Moody’s is certainly not a pioneer. About one year ago Standard and Poor’s had downgraded France and a number of other countries. I had written about it, and here is a part of that post:

There is nevertheless a remarkable news, that went almost unnoticed. In fact, S&P motivates the downgrade with a very clear analysis of Eurozone problems:

  1. A public debt problem.
  2. A Eurozone governance problem (‘an open and prolonged dispute among European policymakers over the proper approach to address challenges’).
  3. A structural divergence between core/surplus countries and peripheral/deficit countries.

The report concludes that the current discussion only revolves on the first of the three problems.  Not only this is not likely to lead to a permanent exit from our woes, but even public finances are unlikely to improve: “As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.

Now, we could be arguing for months about multipliers. Most probably inconclusively, as their size depends on a multitude of factors. But it is undeniable that any action on the numerator of the deficit (or debt) ratio implies adverse effects on the denominator, that is GDP; and that these effects are likely to be larger in times of crisis, when private expenditure is particularly weak. Italy, Spain, Portugal, and especially Greece, are there to prove it. On the contrary, in periods of crisis, acting on the denominator is certainly more successful, because more likely to reverse the deflationary spiral, and to trigger a virtuous circle of increasing income and tax revenues. At least for crisis stricken economies, the key to fiscal sustainability is the denominator of the ratio. Even the IMF famously backtracked on the size of multipliers, and expressed doubts if not on current austerity per se, certainly on its size and pace.

In 1937 Keynes famously said that “The boom, not the slump, is the right time for austerity at the Treasury.” People in Brussels, and Chancellor Osborne, should really go back to the classics.

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  1. March 6, 2013 at 5:01 pm

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