Expand and contract

‘If contractionary fiscal policy can be expansionary, could expansionary fiscal policy be contractionary?’


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.

In other words, when the Italian government rolls over maturing debt or tries to finance the ongoing budget deficit, the interest cost is roughly 150 basis points higher than before. The public debt is 130 per cent of national output. Most of it does not come up for redemption in the near future, but it is obvious that over time the loss of support from government bondholders could cost taxpayers heavily. Over the long run the extra debt servicing charge implied by the 150-basis-point yield shift will be about 2 per cent of gross domestic product. (It will be 1.5 — which represents the 150 basis points — multiplied by 130 and expressed as a percentage.)  

The situation is potentially counter-productive and perverse. Let us compare the extra interest cost with the increase in the 2019 budget deficit proposed by the populists. Before the Lega Nord and the Five Star movement were elected in March, the intention was that the 2019 budget deficit would be 0.8 per cent of GDP; they now plan that it should be 2.4 per cent of GDP. As anyone can see, the long-run cost of the loss of investor confidence (2 per cent of GDP) is greater than the short-run increase in the deficit (1.6 per cent of GDP). It is this arithmetic that is crucial to understanding why fiscal expansions can be contractionary and fiscal contractions expansionary.

Suppose that in coming months Italy’s populists take an even more bolshie line with the European Commission on the deficit target. Holders of Italian bonds are likely to be further disillusioned. The eventual penalty from the higher interest costs may then be enormous relative to the populists’ “fiscal expansion”, not least because the stock of debt is a multiple of any feasible change in the budget deficit. Financial markets may become so alienated by politicians’ behaviour that a bond sell-off precipitates a violent upward surge (of 500 or 1,000 basis points) in bond yields. (This happened with Greece in 2010.)  The increase in debt interest costs then exceeds the rise in non-interest expenditure (on pensions, welfare and the like), causing the budget deficit to explode without limit.

The supposedly benign and positive effects on the economy of the “relaxation of fiscal policy” are smothered by the Frankenstein monster of runaway public debt. There is nothing moronic in warning populist governments — with no matter how many distinguished Keynesian advisers — that they cannot escape the mathematics of addition and subtraction. In extreme circumstances, out-of-control debt interest costs can make attempted “fiscal expansion” contractionary in its effects.