Sunday, September 18, 2011

Balanced Budget

Balanced budget is a consistent topic of debate among economists. Mainstream economics advocates that budget deficits are always harmful and provides a series of arguments such as forward looking expectations of economic agents, crowding out effects and other pseudo-scientific ideas . On the other hand, alternative theories of heterodox economics (especially Keynes and post-Keynesian economists) argue that budget deficits may be useful, and even necessary in times of crisis as they provide fiscal stimulus to sustain aggregate demand. A common view is that budgets did not need to be balanced year on year, but over the economic cycle,  that is with a surplus in booming years and a deficit in recession years, which result over the period in a balanced budget. This view was seen as a synthesis between the two schools of thought but it is now being widely contested by the more radical right wing economists.

The Chicago school of economics - which advocates minimum government intervention and self regulated markets - came under attack in the wake of the financial crisis of 2007-08 . In fact, their economic theory was regarded at that time as an intellectual failure with serious economic consequences. Their belief in rational behaviour and self regulation of markets has contributed to the formation of financial bubbles and therefore to the growing income inequality. Many economists from that school argue that fiscal stimulus plans just create debt-financed government spending which crowds out an private investment - in thes sense that debt absorbs the savings that would normally go to private investment-, even if the economy is depressed , and therefore, they don't contribute to economic growth. P.Krugman is right to say that their ideas about the financial crisis were simply a product of  the 'Dark Age of Macroeconomics ! If public funds are used effectively, i.e. they are geared to finance growth enhancing  investments, they can generate high social returns in the medium to long term. In simple words, public spending does not reduce total investment (in the same proportion), but increases GDP which leads to more savings and tax revenues, and therefore reduces the budget deficit.
The economic debate did not, however, turn into a clear and honest political debate. Fiscal conservatism claims that a budget balance is a primary goal for a society, which means in substance less State intervention and eventually less public services provision, especially to the less favoured groups. This ideology is on the rise  in the US (especially the right wing Republicans) and in Europe (especially Germany and its allies) and its motto is 'no budget deficit', whatever that means. In fact, deficits are not all the same and policy measures to reduce it may vary according to different objectives. But the main point of issue is that austerity alone risks to cause a disaster, as acknowledged by many contemporary analysts (see Martin Wolf in FT 28/06).  

In Europe, wise men say with great conviction that the euro crisis was caused by failure to enforce the stability pact, that is to control limits on deficits and debts. The account balance (i.e. the difference between governments revenues and public expenditure) has worsened in almost all countries, but this is not the cause of the crisis, rather its consequence. Ireland and Spain were considered as the best examples of budget discipline, having budget surplus and low debt level. At the same time, France and Germany, the advocates of financial rigour had high budget deficits and breached the Stability Pact rules during several years for which they never got any sanction and even managed to relax the EU budgetary rules in 2005. Conversely, Spain has exceeded the 3% deficit limit only in 1998 and in the last three years its deficit reached 10%.

Now, the strengthening of the so-called 'economic governance' rules - with sanctions to countries which fail to comply with balanced budget rules - calls for stricter austerity measures which will lead to social turmoil and further economic depression. German and French political leaders urge all the euro area countries to adopt the 'golden rule' - meaning the ban on deficits and debt - and to reform their Constitution in due course. Only Spain has managed to do so, with a bipartisan reform due to internal political reasons. But,  the failure of political leaders to explain the austerity measures in their respective countries  further contributes to the economic mess and makes it even more difficult to solve the current crisis.

Budget deficits are not an economic sin per se.  The idea of a (strictly) balanced budget in times of crisis is not economic wisdom,  but rather a heresy , which in its proper Greek sense,  means 'choice'.

1 comment:

  1. An interesting post which shows how large current account deficits were a key determinant of the euro area crisis in peripheral economies.