A cost of austerity

Might fiscal austerity have even larger costs than generally supposed? I ask because of the interaction between fiscal policy and financial regulation.

Ed Balls says: “An exclusive focus on financial stability could bring a dangerous risk aversion and stifle the real economy.” This expresses a well-known trade-off; we can prevent financial crises by stopping banks lending, but this also stops growth. Given that so much productivity and innovation comes from new companies and market entrants which are often reliant upon bank finance, this trade-off is acute.

So, how can we alleviate it? One way is to reduce the costs of financial crises when they happen, for example by splitting investment and retail banking so that troubled banks can be resolved, or by requiring banks to hold contingent convertible bonds which allows them to be automatically recapitalized in a crisis. In fairness, much of the Vickers report focused upon these issues.

If the costs of crises were low, there’d be less need for tight regulation of banks to prevent crises. Banks would thus be freer to lend, which would help the economy to grow.

And here’s my concern. One way of reducing the cost of crises is to have an active fiscal policy. If governments can increase borrowing greatly, the economic costs of crises are mitigated.

However, two things might prevent governments borrowing in future. One is the euro area’s fiscal compact, which limits structural deficits to 0.5% of GDP. The other - more relevant for the UK - is deficit fetishism. A financial crisis, pretty much by definition, will automatically increase the government deficit. This is because a fall in lending causes some people to become forced savers, and if net private sector saving rises, government borrowing will rise pretty much by identity. A government which takes fright at a big deficit will thus undertake less discretionary fiscal easing than it should. Which means that financial crises hit the real economy harder.

And here’s the problem. If future fiscal policy is irrationally constrained so that the costs of financial crises are greater, then there is more need to prevent them. But this means tighter financial regulation and slower growth now.

I’m making two points here, one “leftist” and one “rightist”.

The leftist point is that the costs of anti-Keynesian fiscal policy are greater than thought. This is because such policy raises the cost of future financial crises and so requires tighter financial regulation now, and hence slower growth.

The rightist point is that this implies that the conventional way of thinking about regulation is mistaken. Very often, such thinking asks: what can rational governments do to constrain the irrational private sector? But this misses the point that governments can be irrational too - not just now but in the future. And if we consider this - as we must - debate about regulation becomes more complex.

Comments

[Zorblog]

Governments can be irrational too, and they often are (at least from the point of view of the well-being of its citizens, not necessarily from the point of view of the people in government).
It can be leftist irrationality (too much spending at the wrong time) or rightist irrationality (austerity now).
This is the best argument against regulation in general.
On the other hand, there is no denying that the private sector is not always rational, and that by serving too much its self-interest, it fails to deliver the beer, bread and meat it is supposed to...
In the end, it looks like it's a question of balance and compromise between liberalism and state-control. Hard to sell, and hard to apply...

[David Ellis]

Austerity will of course deepen the recession and turn it eventually into a depression but who exactly would lend the money for a job creation scheme public or private? Nothing, unless it is monopolised, is profitable anymore. Markets are glutted. Capitalism is snookered: more stimulation will lead to a massive and fatal heart attack further cuts and the patient bleeds to death. Time for a bit of euthenasia.

[Gareth]

"This is because a fall in lending causes some people to become forced savers"

"Saving" is "lending" in the pop macro sense. You probably wanted to talk about desired saving and desired investment. And then you could segue into interest rates, monetary policy, expected aggregate demand, etc etc.

"government borrowing will rise pretty much by identity."

http://www.centreforum.org/index.php/mainpublications/274-lessons-from-the-1930s

You cannot have this discussion without a single mention of monetary policy.

[Ralph Musgrave]

“We can prevent financial crises by stopping banks lending, but this also stops growth..” Yer what? Bank assets relative to GDP have expanded a WHAPPING TENFOLD in the last forty years. That’s according to p.3 of a Bank of England paper “Banking and the State”.

What benefit has that brought? Increased economic growth? I think not. In other words a drastic cut in bank lending made up for by a general boost to aggregate demand would probably do a power of good. But that would mean putting money into the hands of Main Street rather than Wall Street, and that is anathema for the elite, Ed Balls included.

Separating investment and retail banking is obviously a good idea, but did Vickers succeed in doing this? I’ve got doubts because behind their much vaunted “ring fence” money deposited by retail customers can be used by banks to lend to any old dodgy corporation, large or small.

Re your second last paragraph, you make the ever popular assumption that an increased deficit means more government borrowing. This is nonsense. As Keynes and Milton Friedman pointed out, the extra money that government needs to spend in a recession can be borrowed or just printed.

[Andrew]

"The leftist point is that the costs of anti-Keynesian fiscal policy are greater than thought. This is because such policy raises the cost of future financial crises and so requires tighter financial regulation now, and hence slower growth."

Sorry, Chris, another non-sequitur!

"The costs of TB are greater than thought. This is because TB raises the cost of future health care and so requires expensive vaccination and prevention programs, which also have costs."

You can't consider the cost of prevention without considering its benefit.

You seem to have a real issue with ceteris paribus conditions. Here you have implicitly invoked an unameliorated crisis cost and then added in the cost of amelioration without considering the benefit of amelioration.

[Andrew]

Other major logic problem:

"So, how can we alleviate it? One way is to reduce the costs of financial crises when they happen, for example by splitting investment and retail banking so that troubled banks can be resolved, or by requiring banks to hold contingent convertible bonds which allows them to be automatically recapitalized in a crisis. In fairness, much of the Vickers report focused upon these issues.

If the costs of crises were low, there’d be less need for tight regulation of banks to prevent crises. Banks would thus be freer to lend, which would help the economy to grow.
"

The measures you describe lowering the costs of crises when they happen ARE tight regulation.

Conversely, any regulation such as splitting off retail banking or even properly enforcing capital ratios reduces the amount available to lend.

That's why they work, after all, since the problem causing these crises is overleverage, usually on the back of leverage-inflated assets.

[Andrew]

And thirdly there is absolutely no evidence in the world that regulation to dampen leveraged asset price booms depresses long term growth.

Consider your argument here: over the short term, reducing bank lending reduces new entrants and we know that they innovate. Innovation produces growth, therefore over the long term anything that reduces bank lending must reduce growth.

I hate to say it, but non-sequitur yet again. You haven't considered the longer term costs of funding all these new entrants. Particularly the long term costs of misallocation of real resources into bubble assets and related activities.

[Keith]

There is always an unsatisfactory circular aspect to these kinds of arguments.

Leverage on a big scale drives up the market value of Bank assets as demand for the assets is increased by the greater liabilities the banking system has undertaken. Value does not exist independently of this process, which hinges on forecasts about future income from lending no one can really falsify. So how can you ever regulate the system to stop a crisis? Booms and busts are an inherent feature only the size and timing are uncertain. It must be doubtful if any policy private or public can stop financial crisis so this is a bit of a unconvincing discussion about options that do not exist. No one has the knowledge or can have it to actually do what is being discussed.

[Tim Newman]

"However, two things might prevent governments borrowing in future. One is the euro area’s fiscal compact, which limits structural deficits to 0.5% of GDP."

Wasn't the Growth and Stability Pact supposed to do a similar thing?

[Removal Company]

Well, I don't think the euro zone is in a very good state right know which means that its fiscal compact has hard times limiting. But who knows probably there will be some sudden growing urge in the economy.