Barry Eichengreen: Fiscal Fibs and Follies
Fiscal Fibs and Follies: Southern European firms... understand that their countries’ fiscal positions are unsustainable... that debt default would be disruptive... they are holding their collective breath, while evidence that the government is serious about stepping on the brake can induce them to exhale. In this case, fiscal consolidation is likely to affect their investment spending positively.
This does not mean that Greece, Portugal, and Spain will expand as robustly as Denmark, Ireland, and Finland did in the 1980’s and 1990’s. They can’t lower the exchange rate to aid exports. But they can reduce interest rates by eliminating the perceived risk of sovereign default... investment may respond better than the pessimists fear.
But what might work in southern Europe has no chance of working elsewhere... [in] the United States, Germany, China, and Japan.... [T]here is no sign of a brick wall ahead. Interest rates on government debt are still low. If the passengers were growing restive, they would rise. At this point, they have not.... [T]here is therefore no reason to think that fiscal consolidation would have a strong positive effect on confidence. That possibility could arise... it is not on the horizon yet... there would be no positive private-spending response... budget cuts would be strongly contractionary.
Finally there are borderline cases, like Britain. Chancellor of the Exchequer George Osborne insists that his country’s fiscal trajectory is dangerously unsustainable, and he has proposed draconian cuts.... It is almost as if governments like Britain’s are attempting to manipulate the private sector into believing that the dire conditions required for an expansionary fiscal consolidation have already been met... terrorize the private sector, so that when the fiscal ax actually falls, consumers and investors will be sufficiently relieved that disaster has been averted that they will increase spending. If so, leaders are playing a dangerous game.... Or maybe politicians don’t believe any of this and are simply intent on cutting spending for ideological reasons, irrespective of the economic consequences. But who would be so cynical as to believe that?