Week 10 - Fiscal policy, debt sustainability & the Greek debt crisis

Question 1

Troika’s demands - 3 components of austerity cuts to reduce public debt to sustainable demands + 1 more point

Answer 1

Austerity cuts
1. Increase taxes (VAT)
2. Cut public spending (wages and pensions)
3. Sale of state assets

+ Greece needed to improve LABOUR MARKET COMPETITIVENESS through SUPPLY-SIDE REFORMS

Question 2

Measure of debt sustainability

Answer 2

Debt to GDP ratio, 120%

Question 3

2 costs of an excessively high debt level

Answer 3

1. If govt sells lots of govt bonds, demand for funds shifts right. REAL INTEREST RATES INCREASE & deter firms from borrowing. Private borrowing CROWDS OUT INVESTMENT SPENDING.
2. (More serious reason) Excessive debt levels raise CONCERN about DEFAULT
   → increase in COUNTRY RISK PREMIUM
   → firms have to pay higher borrowing costs for investment so investment falls
   - Can lead to a CURRENCY CRISIS, eg. Argentina from 2018-current. Investors doubt the viability of high interest rates as could drive country into recession & thought Argentina couldn’t afford the high interest rates. Experienced capital flight, demand for peso slumped, currency exchange rate slumped. Exacerbated by speculative attacks.

Question 4

What is the significance of the size of the fiscal multiplier?

Answer 4

Related to the debate about fiscal stimulus vs austerity
- Fiscal multiplier tells us given a £1 tax cut, how much does overall income increase?
- Size of FM depends crucially on how much of the tax cut is saved.

Question 5

Keynesian view of the size of fiscal multiplier

Answer 5

Most tax cuts are SPENT, hence fiscal multiplier is LARGE.
1. Marginal propensity to consume is large, hence large FM and large spillover effects
2. A large fiscal multiplier means that austerity cuts can actually EXACERBATE DEBT SUSTAINABILITY (increase in debt to GDP ratio)
» although debt decreases, output decreases proportionately more
3. Austerity cuts can threaten economic recovery during a recession hence Keynesians OPPOSE austerity measures during a recession.

Question 6

Expansionary austerity view of the size of fiscal multiplier

Answer 6

Most tax cuts are SAVED, hence fiscal multiplier is SMALL.
1. Hence adverse effects of austerity would be limited.
2. Austerity can be expansionary & good for economy as COSTS of austerity < BENEFITS. However, rests on the assumption that the fiscal multiplier is small.
3. Due to Ricardian equivalence, ie. ppl save tax cuts.

Question 7

Ricardian equivalence (incl. tax cuts and borrowing constraints)

Answer 7

1. A tax cut today requires an offsetting tax increase in the future. Govt can temporarily run a budget deficit but needs to pay back in future to BALANCE its BOOKS over the LONG TERM.
2. Households SAVE the money from tax cuts b/c they know they will expect to pay a higher tax bill in the future.
   - Households base spending decisions on both CURRENT income and expected FUTURE income.
3. Under RE, tax cuts have NO EFFECT on consumption & aggregate demand
   - b/c the decrease in public saving is offset by an increase in private saving
4. RE does NOT hold under BORROWING CONSTRAINTS

Question 8

Consumption smoothing

Answer 8

1. Households prefer to maintain a constant level of spending over time
2. Arises from the concept of DIMINISHING MARGINAL UTILITY

Question 9

Proponents & opponents of austerity (ref. to consumption smoothing)

Answer 9

1. Proponents of austerity (eg. Merkel) argue that Front-loading TAX HIKES would NOT HARM ECONOMIC RECOVERY b/c ppl would just smooth consumption over time by BORROWING.
2. Opponents of austerity (Keynesians) say that ppl will use TAX CUTS as an alternative source to boost their consumption. Hence, FISCAL STIMULUS is EFFECTIVE in recovering from recession.

Question 10

Why do fiscal multipliers tend to be LARGER in the aftermath of FINANCIAL CRISES? (ref. to tax cuts under borrowing constraints)

Answer 10

1. Ricardian equivalence doesn’t hold in the presence of BORROWING CONSTRAINTS
2. When Greece suffered from a severe financial crisis, banks cut lending due to deleveraging & sudden stop of capital flows.
3. Fiscal stimulus {ie. tax cuts} would’ve BOOSTED SPENDING by giving cash to credit-constrained consumers
   - while tax increases would’ve been severely damaging to consumption and AD b/c ppl couldn’t borrow

Question 11

Cost-benefit analysis of austerity + conclusion from evidence

Answer 11

Costs: AGGREGATE DEMAND
- Small for Expansionary austerity (as RE holds)
- Large for Keynesian (as RE doesn’t hold in the presence of borrowing constraints)

Benefits: DEBT SUSTAINABILITY
- Large for Expansionary austerity
- Small for Keynesian (although debt falls, output falls proportionately more)

Conclusive evidence: austerity is BAD for GDP growth.

Question 12

Chancellor Merkel argued that Greece’s ECONOMIC STAGNATION was due to failure in AGGREGATE SUPPLY, not aggregate demand.
What were the 2 causes for the AS curve to have shifted left?

Merkel argued that Greece needed to implement LABOUR MARKET REFORMS to reverse economic stagnation. What would be the effects?

Answer 12

1. High minimum wage
2. Strong employment protection and union power
3. Real wage depreciation
4. Improve Greek industry COMPETITIVENESS
   -> AS curve shifts right

Question 13

Greece implemented these labour market reforms, real wages fell 20% during 2009-12. However, the policy was unsuccessful & RECESSION DEEPENED.
Why?

Answer 13

1. Due to Greek HIGH INDEBTEDNESS, falling prices did not stimulate economic recovery due to the concept of DEBT DEFLATION.
2. Deflation (falling prices) INCREASES the real value of money holdings but also increases the REAL VALUE OF DEBT
   - CREDITOR experiences an increase in purchasing power. Now wealthier and will INCREASE spending.
   - DEBTOR now has to pay more than £100,000. Harder to repay debt b/c gone up in real terms. Now will CUT spending to repay debt.
   - Debtors have higher MPC than creditors, so the net effect is a reduction in spending (debtors cut spending more than creditors increase spending)
3. Greek firms & households had accumulated significant debts during the boom years.
4. So they CUT SPENDING & paid down debt WHEN PRICES FELL, hence…
5. Impact of falling prices on AD significantly diminished.
   - AD curve has STEEPENED
   - Expansion of AS has lifted impact on the eqm level of output (only a SMALL INCREASE in AD)

Question 14

Why should supply-side reforms in Greece have been COMBINED with EXPANSIONARY MACROECONOMIC POLICY (ie. fiscal stimulus // tax cuts)?

Answer 14

1. Under debt deflation, supply-side reforms shifted AS curve to the right but only small increase in AD b/c AD curve has steepened
   -> output still below full employment QF
2. So need FISCAL STIMULUS for AD curve to shift right & back to full employment

*Rmb that fiscal stimulus alone is not enough! Still needed AS curve to shift right.
- If expand demand w/o expanding supply, there will be inflation.

Question 15

Explain the implications of borrowing constraints for the trade-off between fiscal stimulus vs. austerity in light of these results. (from PS9)

Answer 15

1. In the absence of borrowing constraints, there is no trade-off between fiscal stimulus and austerity due to Ricardian Equivalence.
2. With borrowing constraints, some households cannot smooth their consumption as much as they would like, resulting in UNDER-CONSUMPTION in the short-run.
3. Tax cuts act like a loan from the government, allowing these credit-constrained households to make up the shortfall in their spending,
4. thus boosting aggregate demand in the short-run.

Question 16

4 pros and 7 cons of Greece’s option to reject the terms of the bail-out deal and consequently be ejected from the euro (Grexit)
^from Greece’s perspective

Answer 16

Pros
1. Reintroduction of the DRACHMA is likely to entail sharp depreciation against the euro, boosting EXPORT competitiveness and growth
2. Greece can write off its oppressive debt burden.
3. An END to AUSTERITY measures and their recessionary impacts
4. SUPPLY-SIDE REFORMS might be more likely to be implemented as (i) they can be combined with expansionary monetary policy and (ii) the BENEFITS WILL ACCRUE to Greece rather than its creditors, thus increasing incentives to undertake the painful reforms.

Cons
1. AUSTERITY measures might WORSEN as no bailout loans would be available
2. Currency depreciation would increase import prices, leading to higher inflation
3. Can lead to CAPITAL FLIGHT & higher currency risk premium
4. INVESTOR CONFIDENCE would fall, raising long term borrowing costs
5. Gains from boost to export competitiveness could be limited given Greece’s export share of GDP is relatively low
6. Transitional costs of introducing new currency
7. Structural reforms & fiscal discipline might fail w/o the pressure of external creditors

Question 17

3 pros and 3 cons of Greece’s option to reject the terms of the bail-out deal and consequently be ejected from the euro (Grexit)
^from the perspective of other members of the Eurozone

Answer 17

Pros
1. No more throwing good money after bad
2. Eurozone becomes closer to an optimal currency area {OCA}
3. Might push other members to be more PRUDENT to avoid being kicked out

Cons
1. Grexit might lead to CONTAGION where other countries might also default due to panic & euro might collapse
2. FORFEIT of DEBT REPAYMENTS & might also need to provide large amounts of aid if Grexit led to a humanitarian disaster
3. Membership of euro no longer seen as irrevocable, leading to possibility of SPECULATIVE ATTACKS

Question 18

Why did labour market reforms in Germany led to substantial improvement in economic performance? What are the 2 effects by which the fall in prices boosts AD?

Answer 18

1. Under normal circumstances, HIGH UNEMPLOYMENT puts DOWNWARD PRESSURE on wages,
2. shifting AS curve RIGHT
3. & inducing firms to increasing hiring & PRODUCTION
4. Excess supply of goods > demand means PRICES FALL…
5. which increases AD due to 2 reasons
   i) Real money supply increases, monetary expansion
   - LM curve shifts right
   - Interest rates fall, investment spending increases, component of AD hence AD increases
   ii) Real exchange rate depreciates,
   - boosts export competitiveness, net exports increases, AD increases

Hence back to full employment

Question 19

During the Greek sovereign debt crisis, in negotiations with Greece on the terms of the third bail-out package, the German Chancellor Angela Merkel pushed for swingeing austerity cuts as a condition for approving the bail-out deal.
Why did she believe this would be (i) good for Greece, and (ii) good for the Eurozone as a whole?

[2021 paper]

Answer 19

• Merkel believed austerity cuts were good for Greece as the benefits of improving debt sustainability
  (in terms of a lower country risk premium) outweighed the cost in terms of sapping aggregate demand.
• This stems from the view that the fiscal multiplier is small due to Ricardian equivalence, hence austerity measures would decrease significantly the debt to GDP ratio without harming aggregate demand too much.
• Benefits to the Eurozone came from preventing contagion. If Greece were to default, this would raise concerns about other countries’ excessive debt burdens setting of a cascade of further defaults through a SELF-FULFILLING EQUILIBRIUM and risking collapse of the euro.