Caution: experimental thoughts ahead!
Should countries spend their way out of recession and debt difficulties? For many decades now, a creditors orthodoxy has said that the most appropriate response for a developing country’s debt difficulties and recession is to bring discipline to government finances, spend less and tax more to reduce the fiscal deficit and stop a ruinous cycle of borrowing.
This orthodoxy has been enshrined in the numerous IMF programmes since at least the early ‘80s, long before the formation of any ‘Washington Consensus’. Of course, throughout those decades, only developing countries found themselves on the business end of this orthodoxy, and any critiques that emerged of this thinking were easily brushed aside by the powerful cartel of international financial institutions (IFIs) that represents the interests of sovereign creditors.
Pakistan partook greedily from the coffers of these IFIs since the early ‘80s, but because we were useful pawns in a superpower contest, much of the discipline in public finances called for in these programmes could be dispensed with. Our early borrowings from the IMF — two facilities in the early ‘80s — were both criticised within the Fund as being “mere financing” and no reform.
But in the 1990s all that changed. As we signed onto a Structural Adjustment Facility in 1988, at the conclusion of the Afghan war, the demands for discipline in public finances became serious, waivers became harder to obtain, and reform in the structure of government became the policy north star. For all our self-critical commentary on economic matters, we tend to forget that the decade of the ‘90s saw some very important reform measures advanced, when capital markets were freed up, Sales tax legislation was passed, the first privatisations began, and the power sector was opened up to private investment. None of this would have happened had it not been for pressure from our foreign creditors to bring government finances under control.
And we were not the only country pursuing these policies. Throughout the world, the orthodoxy spread like wildfire with the collapse of the USSR. Eastern Europe and Russia were in the cold grip of ‘shock therapy’, and countries in Latin America and Africa, too, stood on the doorstep of the IMF and struggled with the demands to curb government expenditures and raise revenues.
Strong opposition was voiced against this orthodoxy, and the opposition rose to a crescendo in the wake of the financial crisis in East Asia in 1997. One of the strongest defectors from the orthodoxy was Joseph Stiglitz, who in the wake of the East Asian crisis, famously declared that the IMF had prescribed the wrong medicine, that countries facing a sudden collapse of growth should not retrench their expenditures and should not hike up interest rates, but rather should grow their way out of their difficulties by following a “counter cyclical” fiscal and monetary policy.
In short, Stiglitz was telling the world that the right policy for East Asian countries would have been to spend more and pay for it through short-term borrowing, wait for growth to resume and then let the dividends of that growth pay off the short-term debt. Of course nobody listened to him, at least nobody in a position to make a difference, and even when they did listen it was with jaundiced ears, with extreme prejudice.
But the opposition to the creditors orthodoxy that Stiglitz embodied did not go away and today many of them are having their ‘I-told-you-so’ moment. Today, the orthodoxy has come home to bite, as creditors in the Eurozone struggle with another set of countries that has borrowed its way into oblivion, except this time, the set of countries happens to be in their own backyard.
Today, we behold the spectacle of the creditors dithering in the face of a visceral opposition to their agenda on the streets of Athens. This is no longer food riots in Cairo or a general strike in Lima or student riots in Jakarta. This is Athens — the seat of western civilisation, as we were taught in ‘Civ 100’. This is a country that can say no to its creditors safe in the knowledge that if it goes down, they go down with it. And after weeks and weeks of stalemate, this country has finally done what decades of turmoil in the streets of developing countries was not able to do: it has caused its creditors to blink.
The bail out of Greece agreed to in “marathon” talks that dragged on for 13 hours has “closed the door to a disorderly default” according to Christine Lagarde of the IMF. But more importantly perhaps, the agreement opens the door to further debt write downs in the future and that is the important part. Because with this agreement, the creditors orthodoxy that has a pedigree which spans the decades and the continents begins to come unhinged. Quite possibly, for the first time ever, the representatives of major creditors are questioning whether curtailing deficits should be a bigger priority than safeguarding growth for a country in the throes of recession and burdened with debt.
And that is the crux of the matter for us. Since 2008, we have been committed to a path of austerity in the face of collapsing growth and rising unemployment. Of course, we have not delivered on our commitment with any level of earnestness, but the question is: Should austerity even be the yardstick for us? It’s time to revisit this question I think, because one thing the torturous negotiations around the Greek debt debacle have made very clear is that austerity causes growth to drop, which makes debt servicing even more difficult, which necessitates more borrowing. This is exactly what they call a vicious circle, and where creditors in Europe have agreed that austerity alone will not lead Greece out of its difficulties, I would like to know how the same road is expected to lead us out of our present cul de sac.
Published in The Express Tribune, February 23rd, 2012.
COMMENTS (11)
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Khurram,
Is a 6-7% fiscal deficit which seems to have become the norm "austerity"?
Is a public sector deficit of about 8-10% of GDP (including the circular debt and the PSE sector losses) "austerity"?
Do the astonishing figures of government borrowing from the commercial banks suggest we are following an austere approach?
Does double-digit inflation -- which is becoming more persistent -- point to austerity?
I'm afraid you have really lost me on this one.
Greece has many problems, to be sure. Their biggest problem is tax evasion which is estimated at 48% of GDP. The fat-cats are taking cash out of the country on bicycles and hiding their swimming pools from satellite images!
Over the past decade, Greece has lost 40% in terms of competitiveness. If you have surrendered the option to devalue (by adopting the straight-jacket of the euro), what choice do you have but to devalue INTERNALLY through a reduction in costs and prices? The same applies to the other countries in distress.
Even the last bail-out will not get the debt-to-GDP ratio down to 120% by 2020.
'Since 2008, we have been committed to a path of austerity...' Have we been seeing the same budgets?!! This government has been an utter failure in terms of sound economic policies. Reckless spending has forced the central bank to print of enormous amount of bank notes that has resulted in the drastic erosion of the value of rupee and hence the persistent inflation in our economy. By the way, yeild rate for 1-year greek bonds is more than 100% so I don't care what what the EU does Greece is going to default,period.
@Aftab: In which country does government expenditure trickle down to the common man? All the bailouts in Western Europe and the US, the trillions of dollars have gone to the bankers and investors. In our context, building up the PSDP would be a good idea, then again we dont even have the capacity to spend the meagre amount that is allocated.
The economy at the the state of bankruptcy does need austerity but not the cost of developement
On the face of it, the argument that governments should spend out of a recession looks good but perhaps for the countries where out of every every 100 spent by the govenment, 50-60% goes down to common man who spends it and keeps it in circulation for economy to grow. In Pakistan, this ratio is around 15-20% by all estimates and most of the rest is pocketed by the IFIs themselves, politicians and bureaucrats. In Pakistan the better strategy would be to educe government spendings make more finances available to private sector.
I think a critical piece of the puzzle is whether recessionary forces are owing to lower aggregate demand in the economy or a supply-side shock. Govts can potentially spend their way out of a lower demand scenario (in limited cases), but a supply-side shock such as the one Pakistan is facing (as a result of energy shortage) cannot be resolved only through higher government spending. One can also argue that the sources of Pakistan's lacklustre growth are structural in nature and marginal benefit of improved governance is higher than debt-fueled govt spending.
Finally, the trick can still work, but it will be a risk. It is similar to a business facing cash shortage. Do you cut expenses, or do you spend more to increase revenues? Both can work, but the more risk averse managers will first see where expenses can be reduced without hurting revenue.
Finally some alternative to the mainstream neo-liberal dogma...something which non-orthodox economists have been saying for years
The author asks the imp question "Should countries spend their way out of recession and debt difficulties"? Yes they may do so but only in productive area and not the non-productive like defence which does not create jobs and does not help civilian infrastructure. Without these the progress would be zero or little.
Austerity alone is a good method when one sees that the economy is heading down south. Once the collapse is eminent either spend your way through if the credit is available cheaply or curb spending for survival and borrow the rest for economic stimulation. Most often, in an ill governed state the remedy is too late.
A country cannot spend its way through the borrowed money without appropriate system of sufficient revenue collection. Austerity plan is part of a stimulation package, and there is always a temptation to spend the borrowed money in populist agenda rather than spend it on investment for economic stimulation.
Good article. If I remember it correctly, that is what Keynes suggested as well that govt. spending should be increased during recession to close the gap created by reduced consumer and investment spending. I think the approach you choose to take hinges on the predictability of depth and length of recession; which requires understanding whether recession is part of regular economic cycle vs. irreversible structural change in macro-economic context and markets. Similarly, it also requires understanding of whether the recessionary strain is global vs. local in nature and whether external source of short-term borrowing is available since local borrowing can lead to crowding out of private sector preventing economic recovery.
I think for a start we should not treat all borrowing uniformly. Its the quality of the borrowing that matters, where the money is going and so forth. In Pakistan there is little scope for austerity to begin with. The rich wont pay their taxes, agriculture is holy, that leaves the salary classes who could face potential increases in income tax. GST to VAT didnt work when it should have. On the expenditure side, the military is above account, debt servicing has to be paid, so do government current expenses. Apart from not spending on the PSDP, which we are pretty much not doing as it is, what and where will we cut?