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Expand and contract
December 2018 / January 2019


Contractionary fiscal expansion is an oxymoronic phrase which sounds like an economists’ verbal prank. But its twin — the notion of “expansionary fiscal contraction” — has infiltrated academic journals, sparked off furious debates, and irritated the great and good of global policy-making. In a 2013 book review, Larry Summers, Treasury Secretary for two years in the Clinton Presidency and a well-known Keynesian, dismissed the proposition out of hand. In his view the idea that fiscal contractions (less government spending, more taxes) could promote aggregate demand was moronic as well as oxymoronic. In his view fiscal contraction could not be expansionary in any conceivable circumstances.

But there is a problem. The Keynesian textbooks say one thing; the facts may say something else. Economists with undoubted credentials as scholars and truth-seekers have looked at the data on government spending and budget deficits. They have found that, in several real-world episodes and in more than one country, reductions in government spending have been accompanied by above-trend growth. Professor Alberto Alesina, now at Harvard, but for many years at Bocconi University in Milan, is sometimes regarded as the leader of “the Bocconi boys”. In the early 2010s they cited the evidence of expansionary fiscal contractions as justification for measures of so-called “fiscal consolidation” (or “austerity”) in the eurozone, particularly in their own country of Italy.

If contractionary fiscal policy can be expansionary, could expansionary fiscal policy be contractionary? Italy is about to provide the world with a laboratory experiment to test the question. The present government, a coalition between two populist parties (the Lega Nord and the Five Star Movement), made election promises to raise the retirement age and to slash taxes for small businesses. The European Commission and the European Central Bank have now been told that commitments from past Italian governments — to keep the budget deficit down to levels consistent with their sound-finance rules — will be ignored. As good Keynesians, the populists expect a widening of the budget deficit to generate growth for the Italian economy in 2019. They expect this outcome, regardless of warnings from the Bocconi boys, and bureaucrats in Brussels and Frankfurt.

The spat has upset financial markets. Holders of Italy’s public debt cannot overlook that its government wants to give a higher share of national income to pensioners and welfare recipients, perhaps at their expense. Italian government bonds have suffered heavy selling in recent months, lowering their price and raising their yields. In early 2018 the yield on Italian ten-year government bonds was only 2 per cent; at the time of writing it is just under 3.5 per cent.
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untenured
December 12th, 2018
11:12 AM
There have been many attempts to explain the mechanics of "socialist economics". There is no point. The delusion is that socialists could be curious about accounting for their pipe-dreams. They focus on the scapegoats they see conspiring against them and ruthlessly drop them in the shredder, then move on to the next guilty person. Looking beyond Italy and its struggles with the sticky webs spun by the witless EU, which hasn't got a coherent bone in its body, to the World in general, we find the biggest laboratory experiment has been running for the best part of ten years. The World's currency, the US Dollar, is now available in unlimited amounts, at zero interest, underpinning the incontinent borrowing of all the states that have kicked multiple cans down the road. Which school of economists could predict the outcome?

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