by Don Alexander, MBA
Associate, RSD Solutions Inc.
We recently discussed the issue of fiscal austerity (March 1st) and the implications of being the wrong policy under certain macroeconomic conditions. It has a certain parallel to risk management where conventional measures may not produce the optimal solution.
Giancarlo Corsetti, in a recent VOXEU communique (April 2nd), revisits the issue in "Has austerity gone too far?" He asks the question is austerity self-defeating by keeping Europeans underemployed and destroying the growth required to service the debt. Austerity has not served as a cure-all for market concerns about sustainability, especially with signs of renewed economic slowdown in Europe. Currently, austerity measures in Europe have not produced the desired consequences, but the loss of creditability by not applying it could have made things worse.
The debate is not about the desire for a stronger fiscal stance to manage government debt, but when should the policy mix change during periods of signs of weakness. Under what circumstances should this change be made and limit the damage to policy creditability. Corsetti suggests that countries fall into three categories: one, a group of countries facing a high, volatile risk premium, second, countries with strong fiscal stance and negative risk premium, and a third set that are highly vulnerable to contagion, weak financial sector and high unemployment. The question is how to ensure debt sustainability where countries are subject to different domestic and regional differences.
Corsetti notes the fiscal policy debate has gone through several phases: the first phase was a call for fiscal action to avoid another Great Depression, a second phase, the focus shifted to fiscal consolidation as public debt levels surged, and a third phase, the need for austerity has become less popular with slower global growth. Recent research suggests the emergence of a new paradigm, where fiscal contraction in a liquidity trap environment can be counterproductive. In this paradigm, a number of advanced countries are experiencing high unemployment and underemployment of resources is a self-reinforcing policy. The problem in the current context is fiscal austerity, alone, is not sufficient to tame nervous markets with upfront tightening.
The author notes the government is charged with dealing with the sovereign risk premium. Countries, with high sovereign risks, can adversely impact borrowing conditions in the broader economy and increase the cost correlation between the public and private sectors. Private sector institutions are exposed to sovereign risk: through their holdings of government bonds and they ration credit to repair damaged balance sheets. There are two implications from the sovereign risk channel: first, when sovereign risk is high and fiscal multipliers tend to be lower and second, highly indebted economies become more vulnerable to self-fulfilling fluctuations.
The presence of a sovereign risk channel provides a strong argument to focus on policies that limit the transmission of sovereign risk into private-sector borrowing conditions. Policy options may include: the existence of strongly capitalized banks, policies that may offset high sovereign risk premia and policies that make liquidity available to the private sector. Fiscal austerity is a necessary condition to reduce deficits and lower the risk premium. Under certain economic conditions, austerity may have adverse consequences and other policies are required to reduce the risk premium and limit the impact on the broader economy.
As with risk management, conventional thinking may not produce the desired results.
For more on this follow the link: http://www.voxeu.org/index.php?q=node/7836
