Fiscal austerity and monetary easing: which one is to be praised for ending the euro area crisis?

• Author: Posta, Pompeo Della

1. Introduction

   The euro area crisis has renewed some old controversies about the expansionary or contractionary effects of fiscal policies and induced further discussions on the role of lender of last resort for the private sector to be played by a central bank.

   This paper introduces a framework for the analysis of public debt Stability that refers to the approach proposed initially by Domar, and extends it in order to consider, together with the role of fiscal policy, interest rate and of GDP growth in stabilizing public debt, also the role played by monetary solidarity (that obtains when the central bank is allowed to act as lender of last resort) and by uncertainty (as reflected by agents' heterogeneous expectations) relative to the variables mentioned above and determining the public debt sustainability equation.

   Within that framework it has been possible to analyze the euro area Crisis and the effects on its solution played by fiscal austerity as opposed to monetary solidarity.

   The model also allows to encompass and analyze most of other proposals, including federal solidarity, that have been made in order to avoid or to address future crises.

   The paper is structured as follows. Par. 2 presents the model used for The analysis. Par. 3 presents some evidence on fiscal policy and GDP growth in some euro area countries. Par. 4 discusses fiscal austerity and its effects on GDP growth and interest rates and introduces the 'multiplier effect' and the 'real wealth effect' on GDP growth and the 'uncertain sustainability effect' on Interest rates. Par. 5 discusses the role played by the monetary and fiscal policy Measures in overcoming the euro area crisis and some of the proposals that have been advanced in order to avoid or to address future euro area crises, and Par. 6 proposes some concluding remarks.

2. The solvency condition for public debt

   The continuous time variation of the public debt-to-GDP ratio (d[b.sup.P.sub.t]/dt) in the hands of the private sector can be described, in general terms, as follows: (1)

   (d[b.sup.P.sub.t]/dt) = - s - m - f + (i - g)[b.sub.t]. (1)

   With the term [s.sub.t] = ([t.sub.t] - [d.sub.t]) I indicate the structural primary public surplus-to-GDP ratio at time t, given by the difference between government revenues, [t.sub.t], and non-interest government expenditure, [d.sub.t]. Variable m = d[b.sup.M.sub.t]/dt is the time variation of the public debt-to-GDP ratio which is held by the central bank, expressing then central bank's monetary solidarity (namely a situation in which the central bank is willing to play the role of lender of last resort by injecting money in order to prevent the growth of public debt-to-GDP in the hands of the private sector) and f is the financing coming from a possible source of federal solidarity like the European Stability Mechanism (ESM) (2). With i I indicate the nominal interest rate on public debt and g is the GDP rate of growth, that for the time being are both assumed to be constant. [b.sup.P.sub.t] is the ratio between public debt and GDP that is in the hands of the private sector at time t, and [b.sub.t] is the ratio between the overall public debt (the part which is in the hands of the private sector and the one in the hands of the central bank) and GDP at time t, so that the term (i - g)[b.sub.t] is the growth-adjusted service on the debt as a ratio of GDP. From what precedes, it follows that we are not assuming any favorable conditions for the public debt which is in the hands of the central bank, although especially in the case of stand-alone countries (not belonging to a monetary union) it might be reasonable to consider at least the case in which the service on the debt paid by the government to the central bank goes back to the government. (3)

   For the public debt in the hands of the private sector to be stabilized (assuming then--as De Grauwe (2012) and De Grauwe and Ji (2013a) do--that the public debt which is in the hands of the monetary authority can always be monetized, if necessary), it must be that d[b.sup.P.sub.t]/dt = 0. When that is the case, Equation (1) becomes, then:

   s * + m * + f * = (i - g)b *, (2)

   where the symbol * refers to the long term, steady state value of the variable on which it is applied. Any value of [b.sup.*], such that (2) is satisfied will imply a stabilization of the private debt in the hands of the private sector, so as to avoid a public debt crisis. (4) Of course, if g > i, then the public debt-to-GDP ratio in the hands of the private sector would be decreasing, so that even a given primary public deficit-to-GDP (s

   For the time being, let us ignore both m and f by assuming them as equal to zero. As for m, this was certainly the situation that preceded the celebrated 'whatever it takes' Draghi speech. We will remove those assumptions at a later stage to account on one hand for the role of the ECB as a lender of last resort (by acquiring the public debt not desired by the private sector anymore), and on the other hand to understand what the effects of the evolution of EMU towards a federal union might be. Let us consider, then: (6)

   s * = (i - g) b * (2')

   The equation above says that what matters for public debt stability (still recalling that for the moment we are considering m * = f * = 0), is not just the size of the public debt-to-GDP ratio (on which the euro area crisis literature has focused its attention), but also the interest rate, the GDP growth and the possibility to run the primary surplus which is necessary in order to repay it.

   Over the past decades the interest rate had received a quite significant attention. Pasinetti (1981, 1997), for example, as reported by Arestis and Sawyer (2008) referred to the concept of 'fair interest rate' meaning an interest rate that would allow the easy repayment of public debt by preserving the intertemporal distribution of income between borrowers and lenders.

   Needless to say, when the interest rate decreases so as to reach its zero lower bound, the interest rate instrument of the central bank becomes powerless, and some additional tools have to be devised, as all central banks in the world have been doing in order to face the crisis hitting their respective countries by adopting the so-called non-conventional monetary policies.

   A more general public debt-to-GDP stability condition, however, is the following:

   s [greater than or equal to] s * = (i - g)b *. (3)

   Equation (3) suggests that in the absence of any constraints, a government would always be able to choose s in such a way that the stability of the ratio between public debt and GDP in the hands of the private sector is granted. (7) Public debt will even decrease if s > (i - g)b *. In that case, the reduction of b might also reduce i because of the possibly resulting lower default risk (Corsetti et al., 2013, De Grauwe and Ji, 2013a). Moreover, according to some authors, a sufficiently large primary surplus may also increase g, because the reduction of i would spread from the public to the private sector, thereby increasing investment (Corsetti et al., 2013), and the lower future expected taxes resulting from the lower b might stimulate the consumption of the private sector (Giavazzi and Pagano, 1990, 1996). Both moves, namely a lower i and a larger g, would make the right side of equation (3) flatter, thereby determining a higher critical level for the overall public debt level granting the stability of the public debt in the hands of the private sector.

3. Some evidence from the euro area crisis

   In the Southern euro area crisis countries (Greece, Italy, Portugal and Spain), however, this is not what seems to have happened as a result of 'fiscal austerity': the restrictive fiscal policies adopted in those countries after the Greek shock (8) (see Fig. 1), have been accompanied by a fall rather than an increase of GDP growth rates (Fig. 2).

   Moreover, in spite of fiscal austerity, the public debt-to-GDP ratio in Southern euro area crisis countries kept increasing and stabilized only at a later stage, after the reassurance coming from the ECB that allowed a drop of the risk premium on the interest rates (Fig. 3). The case of Ireland, the only Northern euro area crisis country, is different and its analysis is omitted here.

   The figures seem to suggest also that it is precisely in correspondence With the dramatic change in fiscal policy (that took place in EMU after the Greek shock) that GDP stopped recovering from the 2007-2008 global financial crisis. In turn, the fall in the rate of GDP growth determined, inevitably, an increase of the public debt-to-GDP ratio. (9)

   It might be argued, in fact, that it is precisely fiscal austerity, Implemented in the middle of the global financial crisis, that made the euro area crisis possible: the euro area did not follow what the UK and the USA did during the crisis, namely to operate counter-cyclically in order to soften its negative impact on the economy and to create the conditions for the future recovery.

4. Fiscal austerity and its effects on GDP growth and on interest rates

   In referring to the euro area crisis, let us discuss below the effects of fiscal austerity both on GDP growth and on interest rates.

   4.1. Fiscal austerity and its effects on GDP growth: the 'multiplier effect' and the 'real wealth effect'

   As we have observed in section 3 above, fiscal austerity determined an increase, rather than a decrease of the public debt-to-GDP ratio, because of its influence on GDP growth (that became negative, contrary to what suggested by Corsetti et al. (2013) and by Giavazzi and Pagano (1990, 1996)), and because of its effect on i (that increased).

   GDP growth may become negative after a fiscal contraction for at least two reasons.

   The first one is that fiscal austerity depresses the economy through the standard Keynesian multiplier, which is characterized by a value greater than 1 (Krugman, 2010, Blanchard and Leigh, 2013). This can be called the 'multiplier...