Friday, June 25, 2010

Austerity: A Prisoner’s Dilemma?

Maybe not, but it’s worth a look. The basic idea is that, leaving aside prices (which are flat or falling out to the horizon), fiscal policy can be viewed as having three macroeconomic impacts: on domestic demand, external demand, and fiscal space itself. Austerity is negative on the first and second, but positive on the third. Details (relatively speaking):

Domestic demand: This is immediate and can be assumed to follow some form of Keynesian determination. As long as the fiscal multiplier is greater than zero, cutting deficits will mean cutting income and jobs.

External demand: Similarly, domestic austerity will have a negative effect on demand among trading partners, depending on their bilateral exports (to you) as a share of their own GDP. So austerity in the US would have a large effect on its NAFTA partners, Mexico and Canada, but not much (directly at any rate) on a country like Hungary.

Fiscal space: Imagine that, in the current environment, the risk that bond markets may abandon your country is a sort of lottery. A sudden stop is the cost to be avoided, since it not only raises your borrowing costs, but also drastically narrows your policy autonomy. At any moment you have a given likelihood of losing this lottery over the relevant, multi-year policy horizon; austerity may lower this likelihood. (Actually, this is not clear, as the example of Spain, which was dropped by the markets just after announcing austerity, suggests. But let us make the assumption for the sake of the model.)

Thus, within a range of parameters, austerity could be a PD. This would be the case if the three PD criteria are met:

1. Incentive to defect: the benefits of greater fiscal space (reduction in the likelihood of being attacked by bond markets) outweighs the perceived direct effects on demand.

2. Disincentive to be the sole cooperator: the bond market costs of being the only country to run large fiscal deficits exceed the direct benefits to be had from greater domestic demand.

3. The superiority of mutual cooperation: each country regards itself as better off in a world in which everyone maintains stimulus rather than one in which every imposes austerity.

All are possible.

The first criterion, of course, depends mightily on the weight given by economic decision-makers on economic growth. At present, every country, save those who have no policy space left, is in the hands of the center-right. (I include Obama in this generalization.) For various political reasons, which differ in each country, this has dampened enthusiasm for the direct effects of Keynesian stimulus. Of course, the degree of openness is also germane. The US, for instance, can expect to have a much larger national income multiplier than the much more open European economies.

The second criterion is guaranteed for most deficit countries, the only exception being the US, which enjoys the privilege (and trap) of printing the world’s principal reserve currency. (The only example of bond markets turning against US sovereign debt was during the Carter presidency, but this was based on an inflationary spike, and inflation is not in the cards at this time.) Whether it may hold for surplus countries is an interesting question. Japan has been able to run up stupendous fiscal deficits at no bond market cost. China is more concerned about domestic prices and asset bubbles than bond traders. Germany—what is Germany worried about?

The third criterion depends in part on the other two, plus the extent to which each country depend on exports for its own demand. It could be true, but it depends on all the parameters described above.

Putting all of this together, it would be a project to assess the extent to which PD dynamics play a role in austerity—whether, in other words, the world faces a problem of competitive austerity. You would have to factor in not only the income multipliers and trade coefficients, incorporating n-round effects, but also the difficult-to-quantify perceptions of the costs of depressed income and employment, as well as the risks of a fickle bond market. It’s at least an article, possibly a book (or a doctoral thesis in IPE). Has it all been done before? I remember similar analyses in which the cost of cooperation (stimulus) was a trade deficit, but not the risk of bond market distress. I don’t recall how formal they were.

Thinking through all of this, I think the case for a PD is weak for most countries, and, even if it can be established, most of the policy interest is not at the level of collective action, but perceptions of the cost-benefit tradeoff of stimulus. In other words, unless one is in a world of uniformly small, highly open economies, I think aggressive Keynesianism can be justified one country at a time.

But I’m in the US, a non-small, relatively nonopen, and up to this point monetarily privileged player.

1 comment:

Anonymous said...

I don't think you can make a case for collectively falling on the austerity sword, or even a truly inclusive Keynesian group action acted in a coordinated way.