Austerity or Stimulus?

Three years after President Obama's stimulus plan, the US unemployment rate has hardly changed. Was Obama right to urge a renewed drive to stimulus at the recent G8 Summit? The policy continues to divide economists and politicians. Here, Prof Vito Tanzi takes issue with Martin Wolf of the Financial Times over whether "flexibility" in fiscal policy can be justified with today's economic problems. Tanzi and others warn that cutting the deficit and debt is the best basis for recovery, employment and growth. A group of international economists agree, as you'll see from their signatures below. The letter was sent to the Financial Times but it refused to publish it. You can now read it here.

 

Open Letter to the Financial Times, 30 May, 2012

Sir,

An individual goes to see his doctor to get a medical check up. He is told that the blood pressure and the cholesterol levels are dangerously high and that further increases might lead to serious consequences for his health. The doctor recommends dieting and exercise. For a short while the patient tries to follow the doctor's advice. But the dieting and the exercise make him feel a little tired. A friend, let us call him Martin, tells him that, perhaps, the doctor is wrong and that by eating more and exercising less he might feel more energetic. He adds that, in any case, he could always follow at a later time the doctor's advice.

In a nutshell, the above captures the essence of Martin Wolf's advice to the British government. He seems to be arguing that a doubling of the UK's gross public debt, from 44 percent of GDP in 2007 to the dangerous level of about 90 percent of GDP in 2012, and a huge increase in the general government deficit, from 2.7 of GDP in 2007 to about 9 percent of GDP in 2011 (and even higher levels in the two previous years) should not be cause for concern, at least not immediately. What concerns him is the demand impact of any deficit reduction in the short run. Later, perhaps much later, the government could worry about, and hopefully deal with, the deteriorating fiscal situation.

Obviously, the huge fiscal deterioration of the past four years in the UK's public account, that was only in a relatively small part the direct result of the recession, has not injected enough demand in the British economy. At 8.3 percent, unemployment is on the high side, though not excessively high. Thus, perhaps, a larger dose of fiscal deficit, or at least the continuation of the current high levels would create enough demand to make the economy grow faster. Unfortunately, that continuation would also bring the level of the British public debt dangerously close to that of Italy, a level that worries the financial market. 

The key question that Martin Wolf and others (Krugman, Summers, et al.) who have been taking similar positions, need to address is the following. What is more likely to discourage economic investors: a public debt that moves fast toward Italian levels and that can become unsustainable? Or the beginning of reductions in what have been improperly called fiscal stimuli? This is the classic $64 thousand question.
 

Prof. Vito Tanzi
Former Director of The Fiscal Affairs Department at the IMF, and Former State Undersecretary for Economy and Finance, Italian Government

Prof. Philip Booth
Editorial and Progamme Director, Institute of Economic Affairs
Professor of Insurance and Risk Management, Cass Business School

Prof. Michael Bordo
Professor of Economics and Director of the Center for Monetary and Financial History, Rutgers University, New Jersey, USA

Prof. Steve H. Hanke
The Johns Hopkins University, Baltimore, USA

Prof. David B. Smith
Visiting Professor of Business and Economic Forecasting
University of Derby