01 May 2012

FT: The right kinds of austerity policy

This FT editorial says that elections in France and political upheavals elsewhere are tilting the balance of opinion among policy-makers away from unwavering commitments to deficit cuts. More than ever, clarity is needed about where and which kind of austerity is needed.

Some commentators – many of them American, such as the economist Paul Krugman – condemn Europe’s fiscal consolidation strategies indiscriminately. There is no doubt that the direct effect of tightening fiscal balances is contractionary. But quite apart from the fact that long-term growth requires sound public finances, a lax fiscal policy also has two negative effects on short-term growth.

In the US, the case for fiscal stimulus is strong. In a relatively closed economy government, spending lifts domestic demand without much leakage. The $10 trillion Treasury market is also so big that it is largely a captive one. It is virtually impossible for investors to abandon it, as their equanimity towards last summer’s downgrade showed. An accommodating central bank helps. Similar considerations apply to Japan, if to a lesser degree. In contrast, small and middling countries, including all European states, face a different trade-off. They would only enjoy a muted demand stimulus from unilateral fiscal relaxation; so enmeshed are they in international trade, much of the effect would seep across their borders.

Only globally-coordinated fiscal policy can improve the trade-off faced by small and middling economies. A true growth compact – which should be global, not just European – could let risky states run a slightly less tight ship if safe states bore the brunt of boosting demand. This would take greater leadership than we have yet seen.

Full article (FT subscription required)

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