At The Economist blog Free Exchange, different opinions on the situation of Europe are discussed. More precisely, would fiscal austerity have made a difference, or was fiscal policy the right tool? Examples of economists in favor and against austerity are quoted to show the two positions, but the commentary is too framed on the issue of austerity as if this were the main driver. This framework misses the central point to recovery.
Certainly, austerity measures versus fiscal deficits is an important part of the debate; after all, the European crisis has a fiscal origin. The relevance of a fiscal deficit cannot be overlooked. Recovery, however, does not depend only on fiscal soundness, but also on the market expectations of the long-run situation of the economy. As important as the fiscal policy can be, it is futile in itself if the larger context is not understood. Fiscal stimulus may have a short-run effect on aggregate demand (GDP), but investments and business decisions are done over expected rates of return, not over aggregate demand. An increase in aggregate demand does not imply an improvement in rates of return if fiscal policy is financed via taxes, crowding-out of loanable funds, or inflation and increases in uncertainty. Absent a clear future commitment by the government, long-run investment must be held back until the future regime starts to be more certain.
Economics is not just about economic aggregates, it is about the institutional context and the incentives the framework imposes on economic agents. On one hand, fiscal policy cannot solve the economic crisis, it can only postpone its symptoms. On the other hand, while fiscal austerity may be a necessary condition, it is certainly not sufficient in the presence of high regime uncertainty.
Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.