That sinking feeling

Are we really talking about fiscal consolidation already?

Former German finance minister Wolfgang Schäuble is known for his adherence to monetary and fiscal rigour and a recent opinion piece in the Financial Times confirmed his reputation. He argued for a “return to monetary and fiscal normality [and that] the burden of public debt must be reduced.  Otherwise, there is a danger that the Covid-19 pandemic will be followed by a “debt pandemic”, with dire economic consequences for Europe … Thus, all eurozone members must engage in efforts to return to stricter budgetary discipline.” It is striking that following the biggest economic hit since WWII we are already hearing calls for fiscal tightening. Whilst acknowledging that there will come a point when fiscal support will have to be eased back, such calls require more nuanced thinking than Schäuble tends to apply to fiscal issues.

In what sounded suspiciously like a lecture to the finance ministers of euro zone member states, notably Italy, Schäuble noted that “the need to pay back the debt later is often overlooked. Many governments focus on the “easy” bit of Keynesianism – borrowing – and then postpone repayment of their debts.” This is, of course, not true. If bond investors were worried about not getting their money back they would cease purchases of euro zone debt. Aside from the obvious case of Greece (of which more later) that has not happened. Indeed, many EMU member states have agencies dedicated to managing the national debt which is an indication of how seriously they take the problem.

The article appeared to be based on a misunderstanding of how fiscal policy works, which is somewhat unfortunate from a former finance minister. For a start, he makes the amateur mistake of treating public finances in the same way as those of a household. In other words, he fails to account for the near-infinite lifespan of a government which allows debt to be repaid over multiple generations. And if he is worried about governments borrowing but not repaying debt, Schäuble might want to take a look at the level of German public debt which has doubled in the past 25 years at roughly the same pace as Italy (chart below).

Schäuble’s Italian concerns

That said, Germany’s performance in holding down its debt-to-GDP ratio is far better than that of Italy (chart below). Whilst the level of gross debt has increased at roughly the same pace since the mid-1990s, the fact that Italian GDP has grown more slowly than Germany means that there has been a significant divergence in the debt ratio performance. Italy has struggled to generate decent growth in the two decades since it joined the single currency. This can partly be ascribed to low productivity growth in a fixed exchange rate environment and there are many who believe that Italy’s days in the euro zone may be numbered.

The travails of the Italian economy can wait for another day but you can be sure that if Italy proves to be the catalyst for another euro zone debt crisis it will shake monetary union to its foundations. Precisely because it is in nobody’s interests to allow the euro zone to fall apart, the economy has to be managed in a way that accommodates the fiscal position of southern European countries. Whilst this is not what Germany signed up for, and Schäuble’s views are coloured by those of the people he serves – the electorate – politicians across the euro zone have to take some of the responsibility for allowing Italy into the single currency knowing that it failed the excessive debt criteria.

And he has form on Greece

For all Schäuble’s concerns about Italy, his role in the Greek crisis as German finance minister highlighted the perils of adherence to economic orthodoxy. After Greece was forced to put in place stringent austerity measures in 2010 in return for an emergency loan that was sufficient only to pay interest on existing debt and keep banks capitalized, his insistence on further measures in return for additional aid were more than savage. Former US Treasury Secretary Tim Geithner has recorded how Schäuble was willing to sanction Greece being kicked out of the euro zone, and he continued to hold Greek feet to the fire even in the face of IMF concerns that Greece would be crippled by its ultra-high debt.

The cost to Greece of the fiscal measures forced on them by other euro zone states has been high – even before the pandemic Greek real GDP was almost 30% below mid-2007 levels. In anyone’s book that has to go down as a depression. We can argue about how Greece found itself in such a predicament in 2010 and the extent to which it was the author of its own demise. But the actions of the German government, spearheaded by Schäuble as finance minister, illustrate that the costs of applying orthodox solutions at the wrong time can inflict huge damage. Anyone tempted to heed the siren calls for fiscal consolidation would do well to ponder the Greek case.

He ain’t no Keynesian

In his opinion piece Schäuble invoked the spirit of Keynes. Unfortunately he seems not to have understood Keynes’ prescriptions. He noted that “Keynesian economic experts like Larry Summers or Olivier Blanchard lament the crossing of red lines on public debt and point to the increased likelihood of runaway inflation.” But there is no clear link from high debt to inflation, other than that it is to the debtors advantage if the debt burden can be inflated away. High levels of debt do not, per se, result in high inflation – just ask the Japanese. The criticism levied by the likes of Summers and Blanchard is that a US economy with little spare capacity which receives a big fiscal boost may be prone to inflation, but it is not a question of the debt level itself.

In any case, the treatment of debt did not get a lot of attention in Keynes’ most famous work. In The General Theory of Employment, Interest and Money, I counted 22 uses of the word “debt” and one of them was to point out the perils of reducing it too quickly. As Keynes pointed out, “the desire to be clear of debt” may exacerbate existing economic problems by stimulating more saving than would otherwise occur, resulting in “a diminishing … propensity to consume” – the famous paradox of thrift argument. This is not merely a 1930s problem. IMF simulation analysis conducted in the wake of the GFC pointed out that when all countries are involved in fiscal consolidation with interest rates at the lower bound, the costs of lost output are twice as large as when one country performs fiscal contraction in isolation. If Keynesian analysis offers any insight, it is that there can simply be too much fiscal consolidation.

But we do agree on one thing

Despite the fact I disagree with most of his policy prescriptions Schäuble did make one argument that I found very appealing, suggesting that “a promising approach for Brussels to take would be a eurozone debt redemption pact, similar to the sinking funds devised by Robert Walpole and Alexander Hamilton.” Indeed, I made this very proposal some years ago (here). As I pointed out at the time “few investors will buy undated Greek consols, so the fund would have to be guaranteed by a body such as the ECB.” Last year’s joint borrowing plan suggests that maybe the European Commission itself might be an appropriate guarantor. There are many issues regarding how such a fund might work. Would all countries place debt in the fund or simply those with excessive debt (anything above an arbitrary limit such as 120% of GDP)? The issue of guarantor would almost certainly provoke a political storm.

However we are at the stage where the old pre-Covid orthodoxy no longer holds. As the last decade has demonstrated, unsophisticated consolidation is not guaranteed to produce good outcomes. If Europe is to emerge strongly from the pandemic it cannot afford to be encumbered by navel-gazing over appropriate debt levels. A sinking fund in which a large proportion of debt can be converted into undated consols might be one way to deal with the problem. If even someone as orthodox as Schäuble is talking about it, maybe this is an idea whose time has come.