The best way to run an economy remains one of the most challenging aspects for a country's leaders, with enormous consequences for people's well-being. Sergio de Ferra, a macroeconomist at the University of Oxford, introduces some of the ideas and debates, and explains why it's so hard to really know what works and what doesn't.
Fiscal policy, essentially, is thinking about taxation and government spending. And then, if there’s any gap between them, how you manage that, which is through debt. Are there other important aspects or particular levers of fiscal policy that one should pay attention to, apart from those three basic ones?
That’s correct and you will see that the books I’ve selected are mainly about that last variable—the deficit or debt. Taxes minus spending is equal to the government surplus; accumulating government deficits—which is the negative of the surplus—gives rise to debt.
There are many other important issues that one could consider, but mostly these are not going to be discussed in these books. Maybe you can interview someone else on nuanced details like which taxes you modify, as opposed to taxation in general. Are you taxing firms, are you taxing households? In what way? Those are important questions that macroeconomists, labour and public policy economists have written about a lot. For instance, in developing countries, the ability of governments to tax some sectors of the economy as opposed to others has got important implications. Fiscal policy is a very rich area.
Today, we are going to be talking about themes that are close to what I work on, which is mainly the dynamics of government debt. Perhaps that’s a relatively narrow selection, in terms of topics treated, and others could have a different view of what’s interesting to them. But I’m going to be talking about deficits and debt a lot.
This is a lecture that was very inspiring to me. Sargent had just won the Nobel Prize and I was in the middle of my graduate studies. It was 2011 and Europe was dealing with the consequences of a sovereign debt crisis. Some countries in Europe were facing problems refinancing their debt, and there was a quirk in the institutional arrangement of Europe, whereby these countries with fiscal policy problems—notably Greece, but also Ireland, Spain, and Italy—were in what is known as a ‘monetary union.’ They were in the Euro area. So, unlike most countries in the world, they did not have their own currency.
Lots of questions were being raised about how debt should have been managed in this setup. What was the ideal way to design an institutional arrangement for countries that traded together, shared political decisions and monetary policy but had independent fiscal policy? What role should the Union have? Where should powers lie? What should the Union do? What should the individual countries do? There were all these questions floating around.
Sargent had just won the Nobel Prize, and he gave his Nobel lecture on economic history. It was very interesting because Sargent said something along the lines of ‘I’m an American, I don’t know very much about Europe, but I’m going to tell you a story.’ And the story was a very American story, about the design of the institutional setup of the United States in the 18th century, after the War of Independence. It seemed like this was not directly relevant to the issues that were being debated at the time, but it was actually extremely relevant, which is the reason Sargent brought up this episode.
He made the point that there was a distinct change in the institutions of the United States at the time. There was an initial constitution, the Articles of Confederation (1777), where the federal government had very limited powers to raise tax revenues. As a consequence, it was very hard for the federal government to pay the debt that had accrued to pay for the war. The debt was very expensive to refinance because nobody wanted to buy it. Lenders to the government knew that it was going to be hard for the federal government to service it.
On the other hand, the states—subnational authorities—had all the powers to tax, including international trade, each in their own way. This setup was not working very well.
A few years later, starting in 1787, the Founding Fathers came together and redrew that initial constitution and wrote what is now the US Constitution. In doing so, they changed the location of power. They gave the federal government much greater powers to tax and to manage international trade as a unitary country. So trade of the American states with the Brits was now managed at the central level, not by the individual states. This was an important source of fiscal revenue.
The states gave something to the federal government, and in return the federal government phased out all the debt of the individual states. The federal government took it on as federal debt. It was a bailout from the central authority to the states, which is something that was being advocated for in the European context: ‘We shouldn’t let Greece face this problem on its own, everybody else should help.’ But there was a bargain, because in return for this bailout the federal government allocated to itself powers to tax.
“Fiscal policy is a very rich area”
This changed the institutional setup in the United States drastically. It changed the return on their debt, reducing it dramatically, because lenders understood that that the debt was going to be repaid. The debt could have been defaulted upon, but the Founding Fathers said, ‘No, we’re going to repay this debt. In this way, we’re going to sustain a reputation for being borrowers that can be trusted. It is going to be beneficial for us in the future.’
Also, they changed the fiscal policy setup, moving away from an initial setup where there was lots of decentralisation, to another one where there was much more centralisation of international trade and of important parts of fiscal policy.
So, the issues facing Europe were being talked about in a very indirect way, because Sargent was talking about the United States. The reasons these topics were so interesting—so much so that they were being dealt with in such an important setting as the Nobel lecture—was because the events of the time were making these issues very topical. Many other points are clarified in the lecture, so I suggest watching it or reading the text.
Reading it now, more than ten years later, it’s interesting to notice that the institutional setup of the Euro area, or the European Union, has changed in important ways since Sargent gave that lecture. There’s the issue of Brexit, but that’s not central here. What has happened is that the Euro crisis has been resolved with some intervention from the central government, indeed resembling, in some ways, what happened in the United States 300 years ago. Also, there has been not a complete fiscal union, but some change in the degree of centralisation of fiscal policy in the Euro area, with more powers going to the central authority. I think the European Union resembles the United States a bit more now than it did ten years ago, when Sargent gave the lecture.
The comparison is very relevant. The lecture is delivered in a very sharp way. It’s very clear, very insightful, and touches on many topics of great breadth, which I think is inspiring for a student of macroeconomics or for anybody interested in macroeconomic issues in general.
The European Union put in place some collective instruments to deal with the Greek crisis. Since that time, have they put in other permanent measures to federalise fiscal policy—either raising of taxes or expenditure?
Yes. Big reforms came during the crisis of 2011-2013, with new institutions being created, like the European Stability Mechanism, and greater powers being attributed to already existing institutions, such as the European Central Bank. Then there was a second crisis, which had great relevance for these, which was the pandemic. During the COVID crisis, given that different countries were being hit by it to different degrees—Italy was hit particularly severely in the initial phase—the European Union, as a whole, launched new policies that were unthinkable before, such as borrowing in a centralised way. Europe issued debt of the European Union, which is something that would have been inconceivable just ten years ago.
In the United States, the federal government issues United States government debt—one of the most widely traded securities in the world—while many states are banned from issuing debt. In the European Union, it’s typically the countries that issue the debt, but the distinction has become less sharp in the last three years. The EU issued debt with the specific purpose of supporting national governments to deal with the health crisis. That’s the major change.
Yes. Many of the books I’m going to be talking about today deal with that particular period. I guess that it was a formative period for me. When I was doing my PhD, that’s what I was thinking about, and I hope that the issues remain relevant for younger students. This book was very lucky, in terms of timing, because it came out in 2009, when everybody was talking about debt.
It’s a book about financial crises and fiscal crises, and it’s mainly a review of historical data. Its subtitle is Eight Centuries of Financial Folly, so it takes a very long view on the nature of these crises, dating back to the Middle Ages. I think it was the outcome of a very long-standing research project by the co-authors, Carmen Reinhart and Kenneth Rogoff, and it just so happened that the book came out in 2009, when everybody was thinking about the financial crisis that was taking place at the time. It was very timely and it was a great success. It was a New York Times bestseller, which I don’t think is very common for an economics book containing a lot of numbers and data. (I understand that many readers may think those are scary or challenging, but they shouldn’t).
Why is the book called This Time Is Different? Because there is a common theme. The typical pattern, which the authors highlight, is that during good times, when things go well and the economy is healthy—there is low unemployment, high consumption, and economic growth—debt is accumulated either by banks or governments of individual countries. Or by households, as was the case in the United States in the 2000s.
As you accumulate more debt, you could become concerned that this is dangerous. With more debt, you become more vulnerable to debt becoming very expensive and not being able to repay it. But the typical response is, ‘Don’t worry, because this time is different…for one reason or another.’
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For instance, in the case of the US global financial crisis, there was greater and greater sophistication of financial markets. More and more sophisticated financial instruments were being traded as mortgage-backed securities. There were all these strange acronyms that we suddenly learned about in 2008 and 2009. ‘This time is different because, thanks to these great financial innovations, we can now deal with the greater and greater amounts of debt that poorer and poorer households have.’
Of course, it’s never different. The patterns are recurrent. Many times, these great accumulations of debt end badly, with crises that are painful and difficult to resolve. The book is very insightful in that it contains an overview of how these crises tend to look. What are the points of similarity across crises? What are the differences?
The book talks about different types of crises. It looks at crises that involve banks—and they highlight that bank crises are common both in rich countries and in poor countries; they tend to happen everywhere. They also talk about fiscal crises: external sovereign debt crises, which is when a country—this is typically the case for an emerging market economy—borrows internationally. The government of a country—Argentina is a typical example—borrows a large amount of debt from, say, lenders in the United States. All this debt gets accumulated, and it reaches a point where the government does not find it either possible or desirable to repay it. The debt is defaulted upon. That’s an external sovereign debt crisis, which typically coincides with a recession. The authors discuss in detail the long history of episodes of sovereign default, dating back to English kings defaulting on Florentine bankers in the 14th century. I remember, as a child, going to Siena and being told the story of how the cathedral was not finished because the English king had not paid. That’s a nice anecdote.
This is the one book on your list I’ve read, but—and I wonder whether this has held up—don’t they argue that there’s a tipping point at about a 90 percent debt-to-GDP ratio, where it starts to have an impact on GDP growth?
This book summarises a large body of research by these two authors, their co-authors, and others, but I don’t think it includes that one. But you’re right that among the many papers that Reinhart and Rogoff wrote is this now infamous paper in which they argued that in countries where government debt goes above 90 percent of GDP, growth starts to slow down. That paper was very controversial. There was the story of how a graduate student figured out that the results were incorrect. Some of them were not robust; there was a coding error; and the authors were made fun of because they had used Excel, which is not particularly sophisticated as a piece of statistical software. Some people tried to discredit the authors.
It’s unfortunate because, firstly, I don’t think those results are in this book. Secondly, the contribution of this book, in terms of providing super interesting data and a very clear review of the theories concerning these topics, is very neat and insightful. Instead of focusing on that particular detail, anybody interested in the macroeconomics of crisis—and in particular banking crises, fiscal crises, and the relationship between the two, which is very close—should find this book very interesting.
Let’s move on to The Economics of Sovereign Debt and Default by Mark Aguiar and Manuel Amador.
This third book is fairly technical, more so than the previous two. I think it’s fair to say that this is not a book for a general audience, as it contains a fair bit of advanced maths. It’s really at the frontier of research on the topic of sovereign debt. Think of this as a textbook aimed at advanced graduate students—that’s the audience that the authors have in mind, I think. It’s not a book to read before going to sleep unless you are very smart, but it’s very valuable.
The book is a summary of a set of lectures that Mark Aguiar gave, based on his research and research on the topic more generally. If you want to have an idea of the research that people publishing in top journals are currently doing on issues of sovereign debt, this is a good book. It contains a nice overview of the questions researchers are asking, interesting facts researchers are trying to understand, and the explanations they’ve come up with.
What are we trying to understand about sovereign debt markets? (I say ‘we’ because I am trying to make a little contribution to this research as well!). We’re trying to understand how governments borrow, when they borrow, how much they borrow, at what prices they borrow. We’re trying to understand the implications of this government borrowing and default risk for the business cycles in emerging markets or in countries where there is a sizeable amount of risky government debt.
These are questions that used to be confined to emerging market economies, like Argentina or Brazil or Thailand. But with the European debt crisis, the same type of question started to be applied to countries such as Italy, which is where I come from. It’s a major economy in Europe, and so it’s interesting not just for Italians but for anyone who has an interest in advanced economies with large amounts of debt. A sovereign debt crisis in a country such as Italy would have large and severe repercussions on the wider global economy.
In this book, Aguiar and Amador provide an overview of the state of the literature on the topic of sovereign debt in a very scientific way. It’s not a narrative story. They try and tell the story through data, as Reinhart and Rogoff do, but where Reinhart and Rogoff are really focused on the data and on descriptive statistics about financial crises, here the data is the motivation. ‘Here are some facts that we would like to understand.’ Then, the bulk of the analysis is on the mathematical theory, the mathematical models that researchers have developed to try and understand the behaviour of sovereign debt markets and the key facts that characterize those markets.
Let’s go on to End This Depression Now! by Paul Krugman.
The last two books that I’ve chosen are closely related. You can think of them as being, broadly, two sides of a debate. Again, they’re related to this whole question about the conduct of fiscal policy, but they take different sides. End This Depression Now! is a book by Paul Krugman. Krugman has written other books on very similar topics: The Return of Depression Economics is another related book. In End This Depression Now! Krugman has a very informal tone. It came out in 2013 and is clear advocacy for a particular type of policy. The type of policy that Krugman was advocating was for an increase in government spending.
His argument was that the recession that countries in Europe were undergoing, and the weak recovery that the United States was undergoing, were unnecessary. There could have been greater prosperity, and there was no reason why we were not having it. And the tool to unlock this greater prosperity was a relaxation of fiscal policy: i.e. an end to the austerity policies that were being undertaken in many countries in the world, notably in the United Kingdom. Also, he argues that the US was not doing enough. We should have just spent more, ideally as consumers, but if consumers weren’t doing it then the government should have done more. This would have increased the total level of demand in the economy, which Krugman argues was stagnant, and was the cause of the weak growth.
His point is very clearly, ‘Spend more.’ Governments should spend more to stop this restraint, and by doing so, they will unlock greater economic activity and output. Importantly, he makes the point that greater output will lead to higher income for households and that the social cost of not doing so is extremely high. He says it’s not an issue of numbers. We think of economists as just being focused on the numbers, on the money. He makes the point that the human cost of a recession is very high. Because people can afford less, they eat less, they enjoy life less, and health outcomes are worse.
His second point is, I think, uncontroversial: recessions are very painful events. We should really try to understand how to avoid them and how to mitigate them. I think that every economist or social scientist would agree on that.
His first point—about the recession being unnecessary and caused by excessive government restraint—is extremely controversial. Many people agree, and I think that many policymakers would agree, that governments should do more whenever possible. But it’s not a widely accepted conclusion. I think most of the authors of the books I have suggested would not subscribe to it.
Nonetheless, it’s a very influential view. This is a point that Krugman is making not only in this particular book, but he is also a frequent contributor to the New York Times. He is also a Nobel Laureate in economics (just like Thomas Sargent, although mainly for his contribution to international trade rather than to macroeconomics). Krugman is highly influential, so this is a view that is worth keeping in mind. It’s a view that’s important and receives a lot of attention.
And is clearly being ignored by the current British government.
Yes. The British government was at the forefront of austerity. The point that Krugman makes is that for countries such as Italy in 2011-2013, there was not much leeway. Italy was in the Euro area, so it could not finance government expenditure by relaxing monetary policy. And, at the time, financial markets were not lending to Italy at favourable rates, so the treasury of Italy found itself in a very constrained situation. It did what it could. In Italy or in Greece, austerity was imposed by financial markets or by institutions in the European Union.
That was not the case for the United Kingdom, where borrowing costs were low, inflation was low, and interest rates were low. The UK could have chosen a different track. It could have chosen not to reduce government expenditure in 2010-2015. It could have done something different. That’s the reason why the UK example is particularly interesting, because as opposed to what was happening in southern Europe, the austerity that the UK underwent in this period seemed voluntary, the outcome of a deliberate political choice. Of course, there was an underlying risk that the cost of borrowing for the UK would have gone up sharply as well, had it chosen a different stance of fiscal policy, but that’s what we call a ‘counterfactual’, we cannot know for sure.
Excellent. Let’s move on to the last book: Austerity, by Alberto Alesina, Carlo Favero, and Francesco Giavazzi.
This book takes a very different perspective than Krugman’s book. It’s a more recent book by three Italian economists, one of whom, Alberto Alesina, recently died. The other two are professors at Bocconi University. Importantly, also, these are people that are or have been extremely influential in the political debate. Alesina and Giavazzi have frequently contributed to the policy debate in Italy’s main newspaper, Corriere della Sera. Francesco Giavazzi was an important adviser to the former prime minister, Mario Draghi, so this is a person who had a lot of influence on the conduct of fiscal policy.
Their argument is very different from Krugman’s. They argue that austerity—which is the deliberate conduct of fiscal policy to reduce the government deficit—is by no means the cause of economic recessions. They argue that the picture is much richer than that, and that, on the contrary, there are some instances where reduction in the government deficit may increase growth of the economy.
What this book does is present a statistical analysis by the authors, which leads to their conclusion that episodes of austerity may lead to very different economic outcomes. The key variable on which these outcomes depend is whether austerity is conducted on the revenue side of the government budget or on the expenditure side. Their argument is that you can reduce the deficit in many ways, but if you do so by increasing taxes, this tends to make recessions worse. On the other hand, if you conduct austerity by reducing government expenditure, in line with what the UK has done, this is much less costly and can lead to improvements. This is the argument that they make. This is the core of the book.
“The human cost of a recession is very high”
In addition, they present the data that they have collected and put together to address these questions and put it in the context of the macroeconomic theory behind the possible effects of austerity. They present the theory of the Keynesian side—such as the one underlying Krugman’s arguments—alongside the opposing theory, which emphasises the effects of changes of fiscal policy on the supply side of the economy (the supply side is how much households are willing to work and how many goods firms are willing to produce, rather than how much consumers and governments consume and spend). This is the argument that they make and the framework that they present.
People have very different views and these are the two sides of the debate. The reason why these views have not been settled is that from a statistical perspective, or, more precisely, an econometric perspective, it’s very hard to pin down the effects of these policies, because of a well-known problem in economics—the technical term is endogeneity—which is that we do not have access to a lab. If you’re trying to determine whether giving more food to mice makes them bigger, it’s relatively easy to do so in a lab. You take a hundred mice. You select these mice randomly. To fifty you give one type of food; to fifty you give another type of food. One month later, you weigh them, and you check which one is bigger.
With economies, you cannot really do that, thankfully. It’s not the case that you can take 100 countries, implement a policy in 50 of these countries, and implement another policy in the other 50 countries, and check later on. Typically, fiscal policy and austerity take place in a given context. Governments decide, ‘The economic situation is such that now we think we should do austerity.’ It’s very hard to distinguish the consequence and the cause. All sorts of statistical methods and creative ways of dealing with the data have been developed by economists to try and answer this question. It’s very important but it’s very difficult to answer.
That is a contribution of this textbook. These are renowned economists who have studied these questions. They propose their empirical method and present results that suggest austerity is not contractionary; it depends a lot on how austerity is conducted. They also make the point that there are instances where austerity leads to an expansion of the economy instead of a contraction as Krugman would argue.
When they’re making this argument about the effects of using expenditure or taxation, are they just looking at the impact of that on aggregate growth? Or are they looking at distributional effects? Because I’d have thought the taxation approach might hit the rich harder than the poor.
That’s a very important point. In the textbook, their main object of analysis is aggregate output. The question they address—’What are the implications of aggregate output?’—is already a difficult question. It’s clear that the distributional implications of these types of policies may be very diverse. I think that was seen in the UK, where inequality is high and has been trending upwards. Many people have argued that austerity policies and changes in welfare policies have contributed to that.
Their main focus is on the behaviour of aggregate variables. That’s not because they don’t think that distributional issues are relevant, it’s just that it is so hard to pin down the effects on aggregate growth that maybe it’s worth focusing on that one first and then moving on to address the other question. It’s not because it’s not important, but because it’s even harder to address. In addition, you could argue that you shouldn’t use debt and deficit to solve the issue of inequality, but address it instead with reforms and policies that do not lead to greater government spending than fiscal revenues.
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Sergio de Ferra is an economist at the University of Oxford whose research focuses on international macroeconomics. His particular areas of interest include capital flows, sovereign debt and default, fiscal policy and the euro area.
Sergio de Ferra is an economist at the University of Oxford whose research focuses on international macroeconomics. His particular areas of interest include capital flows, sovereign debt and default, fiscal policy and the euro area.
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