Reducing deficits will lead to a deeper recession

Translated from original French article publsihed in Liberation on April 1st 2013. Thanks to Boris Angelov for help with the translation.

Five years after the beginning of the "Great Recession", Eurozone countries fell back into negative growth in 2012 (-0.6%) and are forecast to continue to shrink in 2013 by -0.3%. At the same time, most European countries are trying to reduce their public deficits. Unfortunately, reducing deficits during a recession risks intensifying the latest economic downturn.

This is not a new idea. In fact, during the Great Depression of the 1930s, Keynes argued that the state must increase expenditures, not reduce them. By increasing the public deficit, the state would sustain demand, resulting in businesses' continued production and employment of workers. In contrast, a deficit reduction would erode demand and further reduce economic growth.

The 2008 economic crisis was a financial crisis, with a reduction in available credit. Homes and businesses needed to reduce their spending and their investments. A reduction in investments during a downturn is counter-productive. In fact, when an economy is beginning to show signs of a slowdown, it is important for businesses to invest in new technologies, and for individuals to invest in their "human capital", for example by upgrading their skills. Given that the reduction of credit reduces private investments at a time when it would be ideal to invest, it becomes extremely important that the state does not follow suit by reducing public investments.

In an article co-written with Philippe Aghion, we used data from OECD countries to empirically confirm the above intuitions. We first showed that a higher government deficit during recession periods than during growth periods (in essence, a counter cyclical budgetary policy) contributes to stronger economic growth. Furthermore, such a countercyclical budgetary policy is all the more beneficial for economic growth when there is little credit available to individuals and businesses. As such, allowing deficits to increase is more beneficial during a financial crisis that drastically reduces available credit than during a more regular downturn. Unfortunately, our article was published in 2007, so we were unable to examine data from the 2008 crisis.

Meanwhile, a recent IMF report written by Olivier Blanchard, Chief Economist at the IMF, and Daniel Leigh demonstrates that European countries that tried to reduce their public deficits in 2008 saw growth below their initial forecasts. These forecasts had already taken into consideration reduced deficits. The fact that economic growth was even weaker than what was expected reflects analysts' under estimation of the negative growth effects of a reduction in public deficits. One explanation for this under estimation is that analysts relied on their experience from the last 30 years, a period without financial crises as harsh as the 2008 one. Additionally, our article with Philippe Aghion suggests that, given the strong contraction in private lending during a financial crisis, the growth effects of a reduction in public deficits are even more negative than during non-financial recessions. Blanchard and Leigh's analysis therefore confirms the negative effects of austerity during a period of financial crisis such as the one experienced in 2008.

The French Auditor General showed in its latest report that the reduction in the budget deficit in France was weaker than predicted for 2012. This was most likely due to the fact that a deficit reduction diminishes economic growth, thus reducing government revenues and increasing expenditures, which ultimately makes it more difficult to close the budgetary gap. This being said, the studies I just quoted do not conclude that one should never reduce deficits. Determining the optimal level of the public deficit is a complex question on which these studies remain silent. Rather than taking a stance on the level of the public deficit, these studies illuminate how deficit levels ought to vary based on economic conditions and the availability of private credit. They demonstrate that public deficit reduction during the current economic crisis has been very costly in terms of economic growth, and that it is more efficient to cut deficits during a boom. In other words, our leaders should think twice about persisting with austerity: beware, danger!

Ioana Marinescu.