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ETUI Policy Brief

European Economic and Employment Policy
Issue 4/2010

Franz Nauschnigg
The author is Head of the ‘European Affairs and International Financial Organizations’ division at the Oesterreichische Nationalbank (OeNB).1

Policy implications
Fiscal consolidation has become necessary following the rise in deficits and debt caused by the financial and economic crisis. Successful fiscal consolidation implies that the private sector and/or the current account compensate the public sector and move to lower surplus or even deficit, otherwise GDP will fall and the economy go back into recession. Given the worldwide nature of the crisis, an improvement in the current account cannot be a strategy for European countries as a whole, as Europe would then also contribute to global imbalances. A form of growth-friendly fiscal consolidation can be achieved, in which private demand compensates falling public demand but explicit policy action is required to achieve this. Such a result was successfully produced in Austria in the 1990s. A shift in public demand from transfers to investments is also recommended.

How to consolidate budgets while avoiding negative growth consequences is a question currently subject to heated debate. Historical experiences – most prominently the USA in 1937 and Japan in 1997 – show that, if, in the aftermath of deep crisis, the fiscal stimulus is taken away, economies can easily fall back into recession. The IMF Managing Director Strauss-Kahn has thus warned that, in the current situation, a very fast elimination of fiscal stimulus will be negative for growth; in the specific case of Europe, the growth problems are more serious than the deficit problems.

The article is structured as follows. It shows that the financial crisis was the reason for the strong increase in budget deficits in recent years (1). It sets out the basic principles for a growth-friendly fiscal consolidation – specifically that, if the government reduces its deficit, other sectors must reduce their surpluses (2). By way of illustration, Austrian experiences – growth-friendly fiscal consolidation from 1995 to 1999 under an Austro-Keynesian paradigm (3) and growth-damaging fiscal consolidation in 2001 under a neo-liberal, paradigm – are described (4) and conclusions drawn (5).

1. Financial crisis causes fiscal deficit/debt explosion
It is not that public debts were at the origin of the crisis but the other way round: the financial crisis led to an explosion of fiscal deficits and public debt. Contrary to what happened in the Depression of the 1930s, this time around policymakers opted for expansionary fiscal and monetary policies: thanks to lessons learnt from the Great Depression, a repeat of this experience was avoided by the pursuit of policy prescriptions that were Keynesian rather than neo-liberal2.

Many crisis-hit countries did not have, before the crisis, high public deficits or debt but, on the contrary, relatively low deficits or even surpluses and relatively low public debt. This is true of Spain, of Ireland, of Iceland in the current crisis, and of Sweden, and Finland in the early 1990s. In these countries it was financial crisis which led to an explosion of budget deficits, debts and unemployment. The main reason for the explosion of the deficits was not discretionary fiscal spending but a decrease in GDP with its negative consequences for the budget. In the EU as a whole, the crisis will lead to an increase in public debt of about 25% of GDP.

After the breakdown of the Bretton-Woods-System in 1971 and the onset of the neo-liberal paradigm, the number of financial crises increased dramatically. Keynes’ insight – in his General Theory – that deregulated financial markets are unstable and that this is systemic for capitalism was forgotten. “The General Theory is thus consistent with the widespread view in the early 1930s: that what had gone wrong had its roots in the imperfections of the monetary-financial system. The greatness of the General Theory was that Keynes visualized these as systemic rather than accidental or perhaps incidental attributes of capitalism” (Minsky, 1975: 143).

The IMF (Laeven and Valencia, 2008) counted 124 banking, 208 currency and 63 sovereign debt crises worldwide from 1970 to 2007, including some 42 cases of double financial crisis (banking and currency crisis) and 10 cases of triple financial crisis (banking, currency and sovereign debt crisis) in which the crises interacted with one another and therefore became especially severe.

Reinhart and Rogoff (2009) show also the high correlation between capital mobility and banking crises (Fig. 1).

Critical voices were ignored. Already in 2003 (Nauschnigg, 2003), the present author concluded that neoliberal reforms – such as deregulation of the financial sector, or liberalisation of capital movements in conjunction with volatile capital flows – are generating financial crises. The reversal of capital flows leads to a worsening of macroeconomic conditions, not economic policy mistakes. As I concluded back then: ‘The question is not if but when the next crisis and the next crash will come and how well we are prepared.’ (Nauschnigg 2003:
284, own translation).

In Europe too we had boom/bust cycles entailing deep financial crisis after the liberalisation of financial markets, e.g. in Sweden and Finland at the beginning of the 1990s, in Iceland in 2008, in Central Eastern and South Eastern Europe (CESEE) in 2009. In all these cases, we witnessed a massive overshooting of capital flows. Again in the Euro Area crisis in 2010, starting with Greece and the subsequent contagion effects on others, we saw extensive market failure: first the countries were flooded with cheap capital through the under-pricing of risk, followed by reversal and overshooting into the other extreme of extremely high risk premia. Financial markets overshoot in both directions. This requires policy intervention to re-regulate and support financial markets. In early 2009 I argued for a
strengthening of the European Financial Architecture as a lesson from the Icelandic crisis, a proposal that was generalised in a contribution to the ETUI’s After the crisis publication earlier this year (Nauschnigg, 2009 and 2010).

The focus in this Policy Brief is on macroeconomic and especially fiscal policy. As noted already, decisive economic policy action has been taken and has prevented the crisis from turning into a repeat of the Great Depression of the 1930s. One consequence of this is that budget deficits have increased substantially, and need to be lowered in the next years. In the Euro area budget deficits increased from 0.6% of GDP in 2007 to over 6% of 2 For an overview of the stimulus packages in Europe see Watt 2009.

Figure 1: Capital mobility and banking crises