1. Evaluate the effects of an austerity fiscal programme in a situation when a government is running negative primary deficits, the nominal interest rate is close to zero, the real GDP is growing, after a period of a prolonged recession and the inflation rate is close to zero.
2. Discuss how your answer may change if the country falls into a deflationary spiral.
3. Briefly discuss Fisher’s Debt-Deflation hypothesis and the Post-Keynesian development.
An unending ripple on the economic health of the nations has been created by the global financial crisis of 2008. In order to stimulate the economy, the governments rely on deficit spending during the time of crisis (Wren-Lewis, 2013). Huge spending capacity of state and inappropriate revenue collection was noticed in European countries. This created deficit bias in those countries (Abbas, et al., 2013). In order to improve fiscal discipline many fiscal institutions emerges. The first purpose of this essay is to discuss the factors that are responsible to accumulate large debt of the government and risks associated with the accumulated debt. The second purpose of this essay is to discuss OECD governments’ deficit financing, which has been increasing rapidly since 1990s. This paper also focuses on the role of fiscal institutions in reducing the debts of the government.
Government revenue declines and social expenditure grows during the financial crisis and government alters its policies according to the phase of cycle that it faces. This further increases the borrowing of the government for the next years. The optimistic approximation of fiscal policy causes the rapid increase in public debt prior to the recent crisis. The following recursive equation represents the debt accumulation dynamics.
Bt = (1+r)*Bt-1 + Gt-Tt
Debt level of present year ( year 1) is positively correlated with debt and government spending of the previous year ( year t-1). Moreover, T is negatively related with debt level. As primary deficit increases the accumulated debt also rises. Accumulation of debt also cause due to the factors like high rate of interest, high borrowing and low investment. The equation of debt accumulation can be further derived by incorporating the level of output Yt.
Bt/Yt – Bt-1/Yt-1 = (r-g)*Bt-1/Yt-1+(Gt-Tt)/Yt
The difference between real rate of interest and GDP, i.e. r-g and the primary budget balance as a percentage of GDP, i.e. (Gt-Tt)/Yt, are the two factors that control the debt dynamics of the government. Positive value of (r-g) causes increase in debt stock. When the same value is negative, the debt stock decreases. A surplus in budget allows the government to finance its existing debt, whereas further borrowing funds primary deficit. If the rate of inflation is high then the bondholders will demand a hike in the rate of interest rate. If the government has significant primary surplus then it might decrease the rate of interest. The Debt-GDP ratio grows slowly at (r-g) rate, , if the GDP increases. When the primary deficit is nil, the debt increases only with the real interest rate. Hence, the growth rates adjust according to the government deficit. In the following section, all of the above discussion will be formalised.
The slope of the main equation that explains debt-GDP dynamics is greater than one. In this case, the interest rate of a country is higher than the growth rate (Figure 1). If debt is assumed to be positive in the beginning, then debt-GDP ratio for t=2; t= 3 etc will be same with debt pinned in the x-axis. This implies that debt-GDP ratio increases at the same rate equal to the growth in rate of interest and Gross Domestic Product proceeds at a lower rate, when the government finances interest payments for accumulated debt with further more debt.
Figure 1:
(Source: Blanchard et al., 2010)
In contrast, when the rate of GDP growth is higher than the real interest rate, it is considered as exotic case. However, the rate is too low for most of the countries so there is no exotic case in the current market. The main equation’s slope is less than 1, as represented by Figure 2. In this case the debt is lower, and attaining a stable level. Here, debt rises at the rate real interest rate is growing. However, it is poorer than GDP growth. So debt will reduce to zero if primary budget is balanced. The debt will still converge even if state runs constant deficits.
Diagram 2:
(Source: Blanchard et al, 2010)
The following main section will discuss solutions for the government handling debt-management.
The rising trends in government debt in the OECD countries during 1970s to 1990s questioned the effectiveness of unrestricted fiscal policy. U.K and the OECD countries focused on reducing the high debt on the part of governments and thus fiscal rules appeared in those countries during late 90s. The number of fiscal councils has been growing ever since the notion of failure of discretionary fiscal rules started to gain momentum. The first fiscal council was established in Netherlands, in 1960. There are thirty fiscal councils has been established by 2013, all over the world. Among the few studies that focus on the effectiveness of the fiscal councils, the research by Debrun and Kumar (2007) stated that fiscal councils helps in improving the performance of nations, as it implements several measures in order to monitor and forecast the future consequences. These councils also provide neutral assessments of the current situation and advices to adopt proper measures to get better in fiscal performance. Since the concept of fiscal council is relatively new, only few researches are conducted related to this.
The journey of fiscal councils and the role played by them in the current fiscal regulation are systematically explained by Calmfors and Wrenâ€ÂLewis (2011). This insightful research presented that the activities of fiscal councils are diversified and they are of huge variety. The growing numbers of fiscal councils demonstrates that the fiscal rules are not enough to certify appropriate operations of the government. The primary role of the fiscal councils is to influence the public debate by planning, forecasting, analyzing or advising the fiscal authorities (Jensen, 1997). However, the primary role of the fiscal authorities is to help the fiscal institution to apply fiscal decisions. Hence, the difference between the role fiscal councils and fiscal authorities is clear.
In a research conducted by IMF (2013) it was stated that the information asymmetry is the major reason behind the deficit bias. These information asymmetries are removed by fiscal rules backed by the fiscal councils. According to the Fiscal Assessment Report, 2012, deficit bias is described as “the tendency of governments to allow deficit and public debt levels to increase”. Information dilemma; electoral competition; common-pool theory; impatience; exploiting future generations and time inconsistency are the factors responsible for deficit bias. The fiscal councils assess the quality of the fiscal policies that are to be undertaken by the government. They have the authority to gather information regarding this. By combining various literature it can be said that fiscal councils’ contributions are several and significant. Before preparing the budgets, these councils provide unbiased and unconditional forecasts regarding the macroeconomic variables. Moreover, fiscal rules of the respective authorities are implemented by the fiscal councils. In addition to this, fiscal councils help the government in finding correct and accurate measures in order to overcome the difficulties present in the current structure (Cangiano, Curristine and Lazare, 2013).
The fiscal councils are established to endorse a culture of lucidity and strength of the fiscal rules in order to enhance the status of the government (Cangiano et al. 2013). Through assessment of plans and finances, these councils help to create sustainable public finances. The functions of fiscal councils clearly indicate it objective. However, despite of several benefits obtained by establishing the fiscal councils, their functioning depends on several reasons like full elimination from political affairs of the state, a strong and efficient communication approach that develops their value in public debate and a persistent supervise of the current fiscal policies of the government. For well functioning of the councils these prerequisites are necessary. By presenting up-to-date information on the fiscal condition of the country, the fiscal council helps to improve the market discipline. Financial institutions do not require to build up the fiscal policy developments of the government but it allows them to focus only on the reports prepared by fiscal councils. Fiscal councils can improve the democratic responsibility of a nation by enlightening voters about the fundamental condition of the financial performance. This is pointed out by the authors Debrun and Kinda (2014). Many researchers also opined that competence of the government spending can be better off with the help of fiscal council (Bohn, 1998).
Office for Budget Responsibility or ORB, which is the official national fiscal council, was established in 2010, in UK. Official forecasts to the government have been proactively made by them, since then. According to the Calmfors and Wren-Lewis (2011), the crucial role of this fiscal body is to offer guidance to the state administration; hence it is a division in the state decision making system. This questioned the sovereignty of the fiscal council, as the government is able to influence or manipulate the council while making a decision. The vigilant status of the council is also doubtful because the council has no right or authority to appraise the outcome of alternate fiscal strategies that the government could have adopted. Government of most of the countries including U.K, have a strong craving for constraining the criticism, which is done by the council to curtail the short-run spoilers that come out from such analysis (Checherita-Westphal and Rother, 2012). This is mainly because of the above aspects; it is sometimes argued that U.K government bring to bear specific stress on the Office for Budget Responsibility. von Hagen (2010 cited in Gianviti, et al., 2010) stated in this regard in his research work. According to him, the reliability of medium-term fiscal goals can be improved through fiscal policies, only if the government of the country has enough commitment. If the government dominates the imposition of decisions and manipulates it assessment regarding the fiscal condition of the country, then the effectiveness of the fiscal councils will be hampered.
Conclusion
It cannot be denied that since the 1970s, the deficit bias is a perpetual trouble of the OECD countries. The global financial crisis of 2008 has fetched the fear and alarmed the developed nations that funding the deficits cannot be cured even in the long run. As in most of the cases, debt financing of this year has led to borrowing and falling into the debt-trap. The major distress of the government of developed countries is its growing debt-to-GDP ratio. Enlargement of the primary deficit, decline in the economies’ overall growth rate of and a hike in the rate of interest; are the three principle reasons identified as responsible for the increasing debt-to-GDP ratio. Growing public debt endangers the government in terms of fall in economic growth through cutback in production efficiency and wealth accumulation. A careful fiscal measure, rise in surplus or sell off assets along with efficient and effective fiscal rule can be used as techniques to lower the debt-to-GDP ratio by the government. In Organization for Economic Cooperation and Development (OECD) countries, fiscal councils have been found to be a very popular concept in the current period. The rationale behind founding fiscal councils is to contribute and improve the usefulness of the fiscal rules made by the government. Fiscal councils aim to eradicate asymmetry in information. It also provides unbiased and absolute forecasts. Along with improving the efficiency of expenses of the government, the councils also focus to advance overall performance of the financial markets. However, some of the councils like UK Office for Budget Responsibility, are not completely autonomous and mostly controlled and managed by the government. Therefore, such types of financial councils are yet to prove themselves capable of improving the overall condition of the economy, in order to facilitate sustainable development.
1. The economic downturns in an economy are not naturally concerned with financial crises but are also concerned with considerable worsening of fiscal positions in the economy. The increase in public debt is due to the decreasing revenues, and higher expenditures have led to a rapid deterioration of fiscal balances. The Great depression in 2007- 2009 had led to rising in increase public debt because the falling of tax revenues resulted in income fall. However, to combat the Great Depression, fiscal stimulus was given which affected the public debt by increasing the value by two fold of GDP. Against these conditions, governments started undertaking policies to reduce the public debt and deficits.
Nevertheless, the government adopted combinations of tax based and spending consolidation measures (Ball et al. 2013). However, the spending based considerations for fiscal austerity can be expansionary such that its tends to be long lasting and can increase in GDP or a small recession whereas the same cannot be said for tax-based consolidations because they are transitory and is connected with a slowdown in GDP growth. However, the two variables mentioned above are the two largest government spending items that are responsive to the reduction in social spending especially on salaries and public wages (Perotti 2013).
Fiscal policy does not operate when the economy is facing a gap in the economic effects. The adverse economic effects can counterbalance the monetary stimulus. Regarding economic consequences if the central banks cut their policy rates to zero in the fiscal austerity period then the set of possible policy is different from the tools that are set and considered in the period of austerity. The zero lower bound of the nominal rates not only have received attention but also have found that the fiscal stimulus would possibly be strong. Hence, fiscal stimulus will raise the expected inflation which will, in turn, push the real interest rate negative that will increase the consumption. However, it can be stated that when nominal rates are zero the fiscal consolidations are expensive (Haltom and Lubik, 2013).
The fiscal austerity on a prolonged period after recession faced substantial distributional effects due to the combinations of spending and consideration tax measures. The main effects are highlighted below:
The effect on inequality and poverty was affected basically due to the changes in the taxes and welfare that accounted for the poorest tenth of the total population. Every measure has reviewed the wealth to increase in the economy by making rich richer and poor poorer. Though the GDP is increased, it accompanied increasing levels of apprehensive work accompanied by obliteration of mechanisms to reduce poverty and lower inequality. Therefore, financial austerity resulted in increased inequality in which the richest continued to gain inconsistently from the new growth in the period after recession (oxfam.org 2013).
A focus on income shares showed that there is a decline in the average incomes and those positions that review an economic fall are also affected by the shrinkage affected by a sizeable number. However, the results for disposable income without the housing costs had adjusted nature in the current income situation whereas as compared with the housing purchases, it did not show any sizeable adjustment in the current income situation. The income changes affected other social, economic factors like health, declines in the academic performance, earnings potential of the children of displaced workers and economic vulnerability (Callan et al. 2013).
The output and unemployment effects of fiscal adjustments resulted in endogenous labour participation and job seekers that were heterogeneously unemployed with an element of “automatic stabilisation”. However, the government system lead to diminished vacancies, high output losses and least benefits regarding deficit reductions. The effect was negative because these effects created an additional wealth in the economy which reduced the number of people employed and ultimately faced a downturn in investment demand and consumption (Bermperoglu et al. 2013). However, the unemployment faced led to a significant long-lasting and long-term unemployment for those who had been unemployed for a long time in the OECD Countries thereby threatening the social cohesion (Ball et al. 2013).
2. The effect of the deflationary spiral on fiscal austerity is the study of the liquidity trap that an economy faces with nominal rigidities at zero level bound. The higher government spending consolidation measures can cause deflationary effects such that it reduces the spending multiplier at the zero level binding rates. However, these confidence shocks are caused fundamentally due to taste shock in which government spending can be checked by inflationary trends and can be related to spending multipliers (Mertens and Ravn 2014).
The problem of the deflationary spiral is because of the replication in the interdependent economies. However, the deflationary spiral theory is valid when it assumes that fiscal policy is efficient and fiscal multipliers are positive (Kitromilides 2011). However, deflationary spirals with shocks have a direct effect on inflation and the monetary tools possess no effect at all because the monetary policy can no more affect the nominal interest rate, therefore, proving its incompetence (Buttet and Roy 2011).
The risk of deflation can also be given by Philip’s curve when the risk of deflation and inflation are examined together based on differences from the unemployment rate from the equilibrium level. However, the model highlights the inverse relationship between the unemployment and price level with the major role of slacks and inflation expectations. One example can be given on the deflationary spiral namely the Federal Open Market Committee that unconfined long-run forecasts of inflation backed by appropriate actions (Williams 2010).
The effect of a deflationary spiral is caused by the balance sheet recession in which the private sector saves instead of borrowings and pays the debt even when nominal interest rates are zero which ultimately results in an economic slowdown. The idea variable is contradictory instinctive because when a single individual cuts down borrowings and saves to pay the debt, then the person’s balance sheet improves. But if the complete private sector does the same thing by minimising its debt without government spending measures, then the economy loses its regular demand and falls into recession rather depression in the long run. However, large cuts in spending can cause a, by and large, effect on the economy as a whole. According to International Monetary Fund’s (IMF), when the private sector is paying its debt, then government becomes the borrower of only remaining option (Koo 2011).
The sequence of the debt and deflationary spiral process are enlisted below.
To combat these deflation debt crises, there is a need for less austerity and more fiscal stimulus. According to Francesco Caselli, more focus should be given to structural reforms than the austerity. However, the time is the best factor to balance the deficit (knowledge.wharton.upenn.edu, 2015).
3. Fisher’s debt deflation hypothesis is given in the instances in 1920 when Fisher views the crashed plateau of the stock market. From the above points of deflationary spiral, Fisher identified a chain of events of distress selling, rising real interests rates, declining asset prices, declining net worth of the economy and rising bankruptcies, credit curtailment, growing distrust, bank runs, asset dumping and hoarding of money depicts that deflationary forces increased the public debt burden. However, Fisher believed that abandoning the gold standard might finish the deflation (Vago, 2009).
Deflationary spiral or debt-deflation is a basic theory of economic cycles, which holds the depression and depression resulting from mostly level of deflating. The credit cycle is the basic case of the trade cycles. In observing the chain of events, Fisher found the ‘great paradox’ where the more the debt is paid, the more the debtor is to be indebted. According to Fisher, it was conventionally propagated the situations of bankruptcies, starvation and unemployment. However, it was argued that the depression could be cured and prevented if stabilization and recovery measures are applied. However, as said by Fisher, deflation increased the public debt burden.
Source: (Vago, 2009)
However, Fisher’s ‘great paradox’ outlined Keynes’s ‘savings paradox. Keynes opines that though the amount of savings by the households will make them hold cash and hoarding cash will increase their incomes. Nonetheless, this will make the households save any amount of money they want. Besides, every saving on consumption will ultimately result in increased income and will counter the theory given by Irving Fisher (Frangakis 2015). About this, there will be no reduction of wages or restriction on the quantity, which will restore its equilibrium back to the full equilibrium level. The fall in prices will not only increase the debt burden but will even increase the money’s value, which remains to be fixed. However, according to Keynes a solution must be devised that will avoid bankruptcies, credit curtailment, growing distrust, bank runs, asset dumping and hoarding of money; essentially that will shudder the capitalist order base (King 2012).
Keynes work was market-based, but it did not formulate the self-regulated mechanism to bring to the level of full employment level with negative expectations. Keynes criticized Fisher’s theory but was not able to provide a proper analysis to the criticism such that the economy will be in underemployment equilibrium due to the lack of credit in the market and less control of the private sector (Shiller 2013).
The Keynes explanation was devoid to support the theory of Fisher because in his theory there were no monetary policy measures that could increase the government or household spending. Though, he even laid the answer to fiscal expansion of the aggregate demand through lower taxes and higher government spending to improve household income in the economy.
The Keynes explanation was devoid of supporting the theory of Fisher because in his theory there were no monetary policy measures that could increase the government or household spending. Though, he even laid the answer to fiscal expansion of the aggregate demand through lower taxes and higher government spending to improve household income in the economy.
One real life example can be given from Greek Crisis that as extensively ensnared with construction of euro zone. However, according to the Greek crisis, the public debt burden is different from euro zone because alternate of Fisher and Keynes theory was applied that means that the fiscal policy operated in different direction (Elliott, 2015).
However, debt deflation is not the only theory that devises bubbles in the economy and Fisher’s theory lacked the basic fundamental role of debt. This theory was revised by Keynes and later my many other theories like Austrian business cycle theory which stated that the economic crisis is the result of low investments and excess growth of credit. Lastly, Fisher’s theory was based on demand side whereas Austrian theory is based on supply side (Prychitko 2010).
References
Ball, L.M., Furceri, D., Leigh, D. and Loungani, P., 2013. The distributional effects of fiscal austerity. United Nations, Department of Economic and Social Affairs.
Bermperoglu, D., Pappa, E. and Vella, E., 2013. Spending-based austerity measures and their effects on output and unemployment.
Buttet, S. and Roy, U., 2011. Deflation, Depression, and the Zero Lower Bound.
Callan, T., Nolan, B., Keane, C., Savage, M. and Walsh, J., 2013. The Great Recession, Austerity and Inequality: Evidence from Ireland. Intereconomics,48(6), pp.335-338.
Elliott, L., 2015. Greece’s problems are the result of the eurozone having no fiscal policy. [online] the Guardian. Available at: https://www.theguardian.com/business/2015/feb/01/greece-problems-eurozone-fiscal-policy-germany [Accessed 20 Jan. 2016].
Frangakis, M., 2015. Public debt crisis, austerity and deflation: the case of Greece. Review of Keynesian Economics, (3), pp.295-313.
Haltom, R. and Lubik, T., 2013. Is Fiscal Austerity Good for the Economy?. [online] richmondfed.org. Available at: https://www.richmondfed.org/~/media/richmondfedorg/publications/research/economic_brief/2013/pdf/eb_13-09.pdf [Accessed 20 Jan. 2016].
King, J.E. ed., 2012. The Elgar Companion to Post Keynesian Economics. Edward Elgar Publishing.
Kitromilides, Y., 2011. Deficit reduction, the age of austerity, and the paradox of insolvency. Journal of Post Keynesian Economics, 33(3), pp.517-536.
knowledge.wharton.upenn.edu, (2015). Does Austerity Work? Or Does It Make Things Worse?. [online] Available at: https://knowledge.wharton.upenn.edu/article/does-austerity-work-or-does-it-make-things-worse/ [Accessed 20 Jan. 2016].
Koo, R., 2011. The world in balance sheet recession: causes, cure, and politics. Real-world economics review, 58(12), pp.19-37.
Mertens, K.R. and Ravn, M.O., 2014. Fiscal policy in an expectations-driven liquidity trap. The Review of Economic Studies, p.rdu016.
Perotti, R., 2013. The debate on the effects of fiscal consolidations.
Prychitko, D.L., 2010. Competing explanations of the Minsky moment: The financial instability hypothesis in light of Austrian theory. The Review of Austrian Economics, 23(3), pp.199-221.
Shiller, R.J., 2013. Irving Fisher, Debt Deflation, And Crises. Journal of the History of Economic Thought, 35(02), pp.179-183.
Vago, S., 2009. Out of Keynes’s shadow. [online] The Economist. Available at: https://www.economist.com/node/13104022 [Accessed 20 Jan. 2016].
Williams, J., 2010. The Risk of Deflation. [online] researchgate.net. Available at: https://www.researchgate.net/profile/John_Williams62/publication/227437498_The_risk_of_deflation/links/0c960524efaa36c80e000000.pdf [Accessed 20 Jan. 2016].
Essay Writing Service Features
Our Experience
No matter how complex your assignment is, we can find the right professional for your specific task. Contact Essay is an essay writing company that hires only the smartest minds to help you with your projects. Our expertise allows us to provide students with high-quality academic writing, editing & proofreading services.
Free Features
Free revision policy
$10Free bibliography & reference
$8Free title page
$8Free formatting
$8How Our Essay Writing Service Works
First, you will need to complete an order form. It's not difficult but, in case there is anything you find not to be clear, you may always call us so that we can guide you through it. On the order form, you will need to include some basic information concerning your order: subject, topic, number of pages, etc. We also encourage our clients to upload any relevant information or sources that will help.
Complete the order form
Once we have all the information and instructions that we need, we select the most suitable writer for your assignment. While everything seems to be clear, the writer, who has complete knowledge of the subject, may need clarification from you. It is at that point that you would receive a call or email from us.
Writer’s assignment
As soon as the writer has finished, it will be delivered both to the website and to your email address so that you will not miss it. If your deadline is close at hand, we will place a call to you to make sure that you receive the paper on time.
Completing the order and download