Greece’s Expansionary Fiscal Contraction Could Have Worked – Only Without The Euro

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It’s rather important that we get this little bit of economics correct. Greece is, as we all know, nailed to that cross of the euro. It’s just leaving the rescue package and it’ll be decades before the place recovers. This is taken to mean that expansionary fiscal contraction cannot work. That’s nonsense because expansionary fiscal contraction wasn’t tried in Greece. Something not tried not working isn’t proof that it doesn’t work.

Larry Elliot in today’s Guardian:

The loss of so much output could have been avoided, but Greece – like the rest of Europe – was subjected to the idea that the priority in the wake of the most serious financial crisis in a century was for governments to balance the books through deflation.

Greece’s problems were triggered when Athens said its budget deficit had ballooned to 13% of GDP in 2009 – much worse than previously estimated. The markets took fright and Athens was forced to seek international help. The original rescue plan involved €110bn (£98.8bn) of financial assistance in return for shrinking its deficit by 7.5 percentage points in 2010 alone.

This was never remotely feasible, but was based on the theory that a commitment to shrink budget deficits and to bring public debt levels down would boost the confidence of the financial markets. Investors would demand a lower premium for holding sovereign debt, and that would result in lower long-term interest rates. Lower long-term interest rates would mean higher growth. In Europe in the years after the financial crisis, the idea that you could cut your way back to prosperity was all the rage. It was called expansionary fiscal contraction (EFC). And it was a complete dud.

Adherents of EFC believed in crowding out: the theory that any boost a government got from spending more on, say, repairing bridges, to boost growth and create jobs would be negated by the higher interest rates needed to finance the deficits that would result. Public spending would crowd out private investment.

But the crowding out theory was inappropriate for the financial crisis and its aftermath, because the banks were dysfunctional, credit flows had dried up and the demand for private sector investment was not there. In those circumstances, when the government was the only game in town, cutting public investment had the opposite effect to the one intended. If consumers and businesses were already retrenching, EFC sucked demand out of the economy. Cutting public sector wages and reducing the value of benefits resulted in lower consumer spending and further depressed private investment.

That’s to misunderstand what EFC was and is in the first place. To start from the beginning.

We’ve two sets of macroeconomic management tools, fiscal and monetary policy. Those to the left of us tend to prefer fiscal policy because an implication of that is that politicians get to spend more money in the pursuit of vote buying. There aren’t that many to the right of us but we prefer monetary policy for exactly the same reason – fiscal policy means being able to buy votes with other peoples’ money.

Good, now we’ve the partisanship out the way it is still true we’ve these two tools. Those who support fiscal policy want to box us all into a corner to show that fiscal policy really is necessary, is the only tool we can use. Thus all thus stuff about how monetary policy is only effective if we’re not at the zero lower bound. After all, we can only reduce interest rates if interest rates are above zero. As recent experience tells us this isn’t true. Short term market interest rates have been negative for some time now. And interest rates aren’t the only monetary policy to hand, we’ve all heard of QE, right?

OK, so this expansionary fiscal contraction. The idea is obvious enough when properly explained. If monetary loosening, monetary stimulus, is greater than any fiscal contraction then we can have fiscal contraction and also a boost to growth. Logically that’s obvious enough, it depends upon that “if.” Can we actually have that much monetary stimulus?

The answer being yes, the great example being the UK in the 1930s. Tories got into power, cut the budget deficit and the economy expanded. Voila! Except we need the other bit too, we came off the gold standard and had a 25% devaluation. The monetary stimulus from the devaluation was greater than the contractionary effects of the fiscal consolidation. It works, it really does work.

At which point Greece. What was the one thing Greece wasn’t allowed to do? Devalue, that’s right, it wasn’t allowed to leave the euro, the gold standard of our day. Thus Greece isn’t an example of EFC and is most certainly not a proof of it not working. And truth be told, if Greece had defaulted and devalued, the standard IMF prescription for the woes it faced, it would have recovered already and would equally be an example of expansionary fiscal contraction working.

EFC does indeed work depending upon circumstances and actions and Greece most certainly isn’t an example of it not doing so. For the simple reason that EFC wasn’t tried in Greece because of the stupidity of the euro.