Few economists would question that John Maynard Keynes was the founding father of macroeconomics, with his hugely influential treatises in the 1930s. Yet, for perhaps four decades leading up to 2008, the influence of Keynes on macroeconomic theory and policy was in steady decline. Then came the Great Recession of 2008-09 and the main themes of the Keynesian approach were resurrected to centre stage of macroeconomic policy. Throughout the world, major economies resorted to large-scale fiscal stimuli and greatly loosened monetary policy. Fiscal deficits soared as governments ramped up public spending and cut taxes. These moves came on top of the “automatic stabilisers” of falling tax revenues and rising payments for unemployment and welfare. “Coordinated” fiscal and monetary stimulus became a dominant theme of successive G20 summit meetings. No wonder, a recent, and justly applauded, biographer of Keynes, Robert Skidelsky, came out with a new book entitled The Return of the Master.
Most economists and policy-makers agree that the vigorous pursuit of expansionary fiscal and monetary policy in 2008 and 2009 were critical in warding off another Great Depression and limiting the recessionary damage wreaked by the global financial crisis (some call it the North Atlantic financial crisis). By the latter half of 2009, a global economic recovery seemed to be clearly under way and the early months of 2010 confirmed much global optimism. By late 2009 and early 2010, the issue of “exit” (from very expansionary fiscal and monetary policy) in major economies became increasingly pertinent, with the initial focus on withdrawing exceptional monetary stimulus. But then came the Greek fiscal crisis, which, over the spring of 2010, snowballed into a wider threat to sovereign debt in southern Europe (the PIGS), to the viability of the euro and to the durability of the global economic and financial recovery. Within a few short months, Keynesian fiscal stimuli went out of fashion and fiscal austerity became the new mantra across Europe, Japan and (to a lesser extent) the United States. The Master was in headlong retreat.
The astonishingly swift change in the prevailing macro-policy paradigm was both remarkable and unsettling. It also raised doubts about the foundations of macroeconomics. Actually, given the rapidity of deterioration in fiscal balances and government debt profiles between 2007 and 2009, the recent lurch towards fiscal austerity should not be all that surprising. According to IMF estimates, overall fiscal balances in the world went from near-balance to a deficit of nearly 7 per cent of GDP between 2007 and 2009 (Table 1). For “Advanced G20 economies”, the turnaround in the fiscal position was particularly sharp, from a deficit of 1.7 per cent of GDP in 2007 to 9.4 per cent in 2009. Even allowing for recessionary conditions and netting out interest payments, the cyclically adjusted primary balance (CAPB) deteriorated from zero to a deficit of 4.4 per cent of GDP. Commentators like Krugman and Wolf have pointed out that this huge swing in fiscal positions of advanced economies was necessary to counteract the massive rise in their private sector surpluses after the financial crisis. That may well be. But one cannot fault the rising apprehension of government bond holders, especially after the Greek imbroglio.
The recent IMF Fiscal Monitor also explores the question of the scale of fiscal correction required in major economies between 2010 and 2020 to bring the currently bloated gross government debt-to-GDP ratios back down to the pre-financial-crisis median level of 60 per cent of GDP by 2030 (For emerging economies, the IMF analysts set the target ratio at 40 per cent because they believe fiscal risks arise at a lower threshold for such countries). The answers are revealing and would not assuage fiscal concerns of government bond holders (see Table 2). For “Advanced G20 economies” as a group, the CAPB would have to improve by a whopping 9.3 per cent of GDP in the coming decade, with predictably high numbers for southern Europe, Japan, the US and the UK. For “Emerging G20” nations, the required turnaround in the CAPB is a much more modest 2.6 per cent of GDP. These numbers highlight the point that just as the “global” financial crisis was located principally in advanced economies, so also the follow-on sovereign debt strains are concentrated in these nations.
Parenthetically, these fiscal projections do not provide much comfort to India, which is an unfortunate outlier among emerging G20 nations as far as fiscal health is concerned. As Table 2 shows, India’s debt-to-GDP is the highest, as is its CAPB and also, therefore, the required fiscal adjustment between 2010 and 2020. Even though the numbers are more onerous (matching the tighter debt target), the broad prescription of medium-term fiscal consolidation is in line with that of the Thirteenth Finance Commission.
For the major advanced economies, substantial fiscal adjustment over the coming decade is unavoidable. The debates rage around timing, phasing and content of measures taken. In Europe, where the sovereign debt clouds over Greece, Ireland, Portugal and Spain are the darkest, fiscal adjustment is under way in most countries. Southern European countries have already taken serious measures. Corrective actions have also been launched in the bigger economies of Germany, France, Italy and, most recently, the UK. An important concern is whether so much simultaneous budget-cutting will deal a serious blow to global economic recovery. Last week’s Economist presented estimates which suggest that outside southern Europe, the proximate levels of fiscal compression are modest (Table 3). For the euro area as a whole, it may amount to only 0.2 per cent of GDP in 2010 and 1 per cent in 2011. So, the alarm over fiscal adjustment leading to serious deflation may be overdone. But it remains a live issue for both the global economy and individual, fiscally-stressed economies.
One thing is sure. Rightly or wrongly, the Master’s dominion over macroeconomic policy in rich countries proved short-lived.
The author is honorary professor at ICRIER and former chief economic adviser to the Government of India. Views expressed are personal
