The economic consequences of the expansionary fiscal consolidation. A tale from Greece

A recent Troika document “strictly confidential”  admits that something went wrong with Greece, since the so called expansionary fiscal consolidation didn’t work:
“Recent developments call for a reassessment of the assumptions used for the debt sustainability analysis. Since the fourth review, the situation in Greece has taken a turn for the worse, with the economy increasingly adjusting through recession… The growth and fiscal policy adjustments assumed under the program individually have precedent in other countries’ experience, but experience to date under the program suggests that Greece will not be able to set a new precedent by realizing at the same time and from very weak initial conditions a large internal devaluation, fiscal adjustment, and privatization program.”http://www.linkiesta.it/sites/default/files/uploads/articolo/troika.pdf [2]

In 2009 and 2010 Greek citizens were said that government spending cuts and tax increases were necessary to expiate past fiscal sins (committed by Karamanlis government) and find a new and sustainable way of economic growth. Among the precedent experiences quoted by the document there are the Danish case in the first half of eighties and the Irish case in the second half. As a matter of fact, a closer inspection of these two experiences suggests that fiscal consolidation may tend to be expansionary only under fairly special conditions, namely when accompanied by a) a fall in the exchange rate that improves the contribution of foreign trade to economic growth, and b) a fall in interest rate levels that improves interest rate sensitive spending by households and firms. Both conditions were present in the Danish and Irish cases. Notice that both conditions are absent in the Greek case, since interest rates have climbed across the periphery, while the euro has been appreciating over the past years.

Moreover, there is a basic policy incompatibility problem that arises when combining a strong fiscal consolidation with efforts at a substantial internal devaluation, in order to gain competitiveness. Attempting to deflate nominal incomes in order to improve trade prospects by lowering costs (one of the few strategies available to improve competitiveness when a nation faces a fixed exchange rate constraint) appears in conflict with attempts to get tax revenues up and meet the fiscal targets. We can see this vicious circle in motion in the Greek experience, with fiscal restrictions, subsequent real (and nominal) decrease in GDP, new fiscal restrictions and so on.

Quoting again the Troika document, we find the following admission: “a combined shock—to represent a scenario of strong internal devaluation enforced by a much deeper recession—would sharply raise debt in the near term. … through much deeper recession and deflation the competitiveness gap is unwound by 2017, instead of during the next decade. The headwinds from the deeper recession are assumed to delay the achievement of fiscal and privatization policy targets by three years. As the economy rapidly shrinks, debt would reach extremely high levels in the short run at 208 percent of GDP…Market access would not likely be restored until 2027...Cumulative additional financing needs … could approach €450 billion.”

Turning back to Denmark and Ireland, both countries benefited by a good rate of economic growth in Europe after the slow down of the beginning of the eighties, with an export led growth (mainly Ireland); the actual economic perspectives are gloomy: just few days ago Draghi called of a “mild” recession coming in the next months; Fabrizio Galimberti (Il Sole 24 Ore 11-5) remarked that to speak of a “mild” recession is similar to say that a woman is “slightly pregnant”. Why the forecast changed so quickly? One reason is the mounting uncertainty on sovereign debt, bank solidity, and so on, but the other one is the restrictive fiscal policies implemented at the same time all over Europe.

The idea, shared still now by many economists, is that cutting public expenditures now means lesser taxes tomorrow, and the effect is positive on consumption and investment; this “expectation view” ( called also German view) on a priori ground may be right. It is reminiscent  of the ricardian equivalence between public debt and wealth tax. But the point is that consumers are not so smart as those economists; the cut of disposable income induces a cut in expenditures, and as a consequence firms cut their investments.

As Parenteau said “Greece is not a special case, but rather a case in point of what happens when you attempt fiscal consolidation in countries with high private debt to GDP ratios, high desired private net saving rates, and large, stubborn current account deficits – conditions, by the way that also apply to France. Expansionary fiscal consolidation are possible, but they are not automatic: in fact, they require very special conditions. Pursuing internal deflation at the same time a financial consolidation is underway insures the latter effort will be thwarted as domestic incomes deflate. We must conclude the Troika’s policy approach has been an abject failure – indeed, they appear to have finally concluded as much themselves. It is high time to explore entirely new policy directives before the remaining eurozone economies are driven into the ground under what appears to be a faulty, faith based economics of the Troika”.