Dollars, Euros, and Debt

The financial, economic and fiscal crises — the “Great Recession” — that rocked many countries in the years after 2007 have continued to influence the economic developments of several countries, especially but not only in Europe, and, within Europe, in the euro area. In some of their aspects, the crises have generated interesting and at times unexpected reactions on the part of both economists and policymakers. These unexpected reactions could be interpreted as reflecting intellectual flexibility on the part of some, opportunism on the part of others, and perhaps also continued optimism on the part of others still, with regard to the impact that particular policies can have on economies.

We shall start with a discussion of whether Keynesian fiscal policy can still be used to promote an economic expansion in the countries in crisis, given the precarious fiscal situation of many of those that are still experiencing high unemployment, economic slowdown, or even recessions. The use of discretionary, or active, fiscal policy, to counter the economic and social effects of recessions, as proposed by Lord Keynes three-quarters of a century ago, has been widely debated, especially since the start of the Great Recession in 2008. Some of the participants in the debate — which has involved economists, policymakers, civil servants, financial operators, reporters, union leaders, and even normal citizens — advocated, and have continued to advocate, a relaxed fiscal stance, one that in their view would maintain or even increase, in the short run, the high fiscal deficits that many countries have been experiencing. These individuals have continued to argue that such a fiscal policy (which would require higher fiscal deficits) would help sustain a higher aggregate demand (as Keynes had theorized, during the “Great Depression” of the 1930s). They see the current economic difficulties of countries mainly in terms of lack of sufficient aggregate demand, in spite of very high current fiscal deficits that for sure must be contributing to aggregate demand. The high fiscal deficits are too high to be attributed to the falls in the countries’ GDPs.

There have been strong pressures on the European Central Bank to play the role of the traditional, rich and generous uncle, for some of the countries that use the euro. Many observers have been urging the ECB to buy, directly, from the issuing governments, or indirectly, through the secondary market, the bonds of the governments of the countries in difficulty. It has been argued that this action would keep the spreads low, without leading to inflation, because of the high unemployment and excess capacity that exists in those economies. It has also been argued that the spreads may not be justified because they are the result of irrational confidence crises fed by some “herd behavior” on the part of holders of government bonds. Some other observers, and especially Hans-Werner Sinn, a German economist, in several recent papers, have argued that so-called TARGET2 balances have indirectly allowed huge funds to work their ways to countries in difficulties, and especially to Greece, thus reducing the need for these countries to adjust. We shall discuss later, in another chapter, this complex issue that has attracted much debate, especially in 2012.

In evaluating some of the various policies that have been proposed by experts to deal with the crisis, some important factors must be considered. Some of these are discussed briefly below.

An empirical study co-authored by the author of this book — written for a seminar on public debt and fiscal policy in EMU, held at the European Commission in Brussels on 17 September 1999 at a time when EMU had just become official — concluded that: “A growing public debt appears to lead to higher direct taxes, lower public investment and, ultimately, a lower growth rate. In addition, higher debt does seem to crowd out private capital formation and raise interest rates.” It added, “[E]vidence for the EU suggests that it is possible [that] lower debt will have non-negligible [positive] effects on growth rates…” Therefore, “[T]he welfare impact over time of lowering public debt could be large” (see Tanzi and Chalk, 2000, p. 41). The conclusions of that study were ignored at the time they were presented and for several years afterwards, even by economists interested in the topic. Only many years later, when public debt started to attract attention, were those conclusions endorsed or challenged by various studies that had consistently failed to cite it.

The creation of the European Monetary Union had given, at least in a statistical sense, large, additional fiscal space to the member countries, by sharply lowering the interest rates they had been paying on their public debt. This lowering of interest rates was in part more apparent than real, because it was due to the fall in nominal interest rates caused by the fall in the inflation rates. The real interest rates had fallen much less than the nominal rates. For several countries, including Belgium, Greece, and Italy, the lowering of the nominal rates on their public debt had reduced their share of GDP by several points. For example, from 1995 to 2003 the interest payment on the public debt had fallen in Belgium from 8.9 percent to 5.3 percent, in Greece from 11.3 percent to 5.0 percent, and in Italy from 11.5 percent to 5.1 percent. Because of these reductions, the countries’ governments must have felt suddenly richer. They must have believed that their fiscal policy had become far more sustainable. Unfortunately, the fiscal space so created was not used to reduce the public debt, as the countries might have been expected to do. In several countries the acquired fiscal space was instead used to increase public spending.

In this chapter we discuss some reasons why unemployment rates tend to remain high for a long time after the bursting of bubbles and why fiscal stimulus packages often tend to be disappointing in terms of job creation. This has clearly been the case in the most recent years in the countries that have experienced the Great Recession. The reason is mainly that labor is much less fungible than Keynesian fiscal policy has assumed it to be and that workers find it much more difficult to change jobs than assumed by Keynesian economics. Furthermore, it can be theorized that the difficulties described in this chapter are likely to grow as the countries’ economies become more advanced and complex.

From the time when the European Monetary Union was being created, several American economists, including prominently Milton Friedman and especially Martin Feldstein, in several academic and more popular articles, maintained that the EMU was a “structurally flawed project” that did not have much chance of success or survival. In the views of these and some other economists, mainly from the US and the UK, there were intrinsic and fundamental weaknesses in its design. For Friedman the main problem for the EMU was that of having fixed an important price (namely the exchange rates) permanently, between countries that were likely to have different productivity gains over the years. Friedman was a strong believer in flexible exchange rates and in free prices where the market determines the prices. As a consequence he went as far as predicting a life expectancy for the euro of no more than ten years. (See his 1997 article and Martino, 2008.) It is not clear why this problem would not affect economic relations, say, between California and Texas, which also have a fixed exchange rate between them (they both use the dollar) and that may experience different productivity gains over the years.

No data are available on the internal balance of payments of American states, or regions. If such data existed they would, for sure, show large disequilibria among the American states or regions, with surpluses in some and deficits in others, just as they do in Europe. For example, when the car industry got into trouble, Michigan, where much of car production was located, must have experienced a major deterioration in its trade balance with the rest of the United States. The states that have started to produce energy from new sources such as shale must have experienced, initially, large deficits in their accounts with other states, because of the capital that they must have needed to import in order to develop the local energy sources. In time the balance will shift in favor of these states, when they start exporting energy on a large scale.

While Feldstein gave a lot of importance to the labor market, stressing that Europe’s was not a single market, and to the role of fiscal rules and of the existence of a central fiscal authority in the US, he ignored, or downplayed, other factors that might also be important. One of these is the specific arrangements that exist, within the US and within the EMU, that make it possible for private banks, located in different states within the US, or in different countries within the EMU, to have financial relations between them and to move funds from one part of the union to another part. These arrangements may be influenced by financial crises, which may reduce the trust that banks have in each other, and affect the normal relations that exist between them in normal times. They may also influence the way crises develop over time.

The Great Recession started, as a financial crisis, in the United States, connected with bad investments in the housing market. Soon it changed into an economic recession, and, finally, morphed into a fiscal crisis in an increasing number of countries. In spite of growing worries, so far it has not affected the cost of borrowing for the American government, a cost that has remained surprisingly low in spite of some recent increases in rates. In Europe the crisis had more varied origins and it created difficulties both for countries and for the euro, raising questions whether the euro, as the common currency in the European Monetary Union, would survive the crisis.

There is an important aspect of the growth of public spending that has not attracted the attention that it deserves and that may be an important element of an exit strategy based on reducing public spending over the medium and long run. It is an aspect connected with what could be characterized as a “fundamental law of public expenditure growth over long periods of time.” It is a law, or at least a consistent trend, that has attracted little formal attention, even though it seems to have contributed much to the long-run growth of public spending in many countries, after the original welfare state programs were created in distant decades. The law focuses on the growth that took place in the public spending of many countries in the years after the introduction of the landmark social legislations, in Germany with Bismarck, in the US with Roosevelt and Johnson, in the UK with Beveridge, and in other countries with similar legislations. (See Tanzi, 2011a: ch. 5.) The law focuses on the fact that public spending growth often comes in small steps and not in big jumps.

In this study we have argued that the difficulties that the EMU countries have been experiencing have had less to do with the use of the common currency, the euro, or even with the characteristics of the European Monetary Union, and a lot to do with the levels to which public spending was pushed over the years combined with limited and inefficient controls on banks and on the financial system. These developments made it easier for countries to finance large public spending until concerns about the sustainability of their fiscal accounts started to affect borrowing costs. For example the purchase by Cypriot banks of Greek government bonds made it easier for Greece to expand its public spending and in turn created problems for Cyprus. In most of the countries of the EMU, but also in other countries including the United States, with the help of foreign loans, public spending had been pushed to levels that, sooner or later, would become unsustainable and lead to potential fiscal crises.