Yet the budget cutters have a fallback position. The problem with fiscal stimulus, they say, is that it destroys confidence in government finances, thereby impeding recovery. So a credible deficit-reduction program is needed now to “consolidate recovery.”
What is it about cutting the deficit that is supposed to restore confidence? Well, deficit reduction may lead consumers to believe that a permanent tax reduction is on the horizon. This will have a positive wealth effect and increase private consumption. But why on earth should consumers believe that cutting a deficit, and raising taxes now, will lead to tax cuts later?
One implausible hypothesis follows another. Fiscal consolidation, its advocates claim, “might” lead investors to expect improvement on the supply side of the economy. But it is unemployment, loss of skills and self-confidence, and investment rationing that are hitting the supply side.
We are told that the “credible announcement and implementation” of fiscal-consolidation strategy “may” diminish the risk premium associated with government debt. This will reduce real interest rates and make “crowding in” of private spending more likely. But real interest rates on long-term government debt in the US, Japan, Germany, and the United Kingdom are already close to zero. Not only do investors view the risks of depression and deflation as greater than those of default, but bonds are being preferred to equities for the same reason.
Finally, the reduction of governments’ borrowing requirements “might” have a beneficial effect on output in the long run, owing to lower long-term interest rates. Of course, low long-term interest rates are necessary for recovery. But so are profit expectations, and these depend on buoyant demand. No matter how cheap it is for businessmen to borrow, they will not do so if they see no demand for their products.
The ECB’s arguments look to me like scraping the bottom of the intellectual barrel. The truth is that it is not fear of government bankruptcy, but governments’ determination to balance the books, that is reducing business confidence by lowering expectations of employment, incomes, and orders. The problem is not the hole in the budget; it is the hole in the economy.
He makes reference to an article in the July issue of the ECB Monthly Bulletin ('The effectiveness of euro area fiscal policies', p. 67) and I would advise IB year 2 Higher Level (but even interested standard level) economics students to read carefully section 2 (pp. 68-71) titled 'Fiscal policy effectiveness: theoretical considerations". Skidelski's piece can be then thought of as an evaluation of the ECB position. The July issue of the ECB's monthly bulletin can be found here.