by Forni Lorenzo

My primary motivation for writing this book is that, all too often, economic policy seems to do harm and impose unnecessary costs on populations of many different countries. These costs result in the waste of scarce resources, which could have been used more productively – to alleviate the suffering and deprivation of the most vulnerable social groups and, more generally, to contribute to the broader well-being of the entire national community. This damage is almost always due to poor economic policy choices based on distorted beliefs about how national economies work.

politicians tend not to want to respect budgetary constraints. For them, the temptation to spend in order to buy consensus, with no one footing the bill, is strong, and as strong is the temptation to make others pay for their past excesses. The willingness of politicians to meet the growing demands for voter protection pushes them to promise and, sometimes, to implement policies that economists often consider ineffective and unsustainable in the medium to long term.

certain unsustainable policies have been implemented in the attempt to create more wealth and greater well-being, so that voters, as far as possible, are satisfied. However, often, the politicians’ horizon is short – extending to the next elections – and, therefore, they may be interested in supporting the economy only in the short term, without regard to whether the policies adopted are appropriate for the medium to long term. However, and this is a fundamental point, unsustainable macroeconomic policies sooner or later lead to crisis. Crises manifest themselves as more or less long and deep recessions, in which past excesses are corrected and citizens are called on to pay for them. If fiscal policy distributes resources that have not been produced, if a country spends more than it produces, in the end, someone has to pay for it: in short, sooner or later the budgetary constraint takes over. This leaves the question of who should pay, because in the distribution of the burden there is some leeway.

Interestingly this conflict between politicians and economists has often been seen in many developing countries and in dictatorial regimes. In the latter, as we shall see, the conflict is peculiar because dictatorships do not need democratic legitimacy and can therefore afford choices that would not be possible in other countries. But in many emerging countries the conflict has been and is still ongoing. There was a long sequence of economic policy errors in various South American countries that led to public debt crises in the 1980s, just as there were the Asian and Russian crises of the late 1990s. The most emblematic case, with a long history in this regard, is that of Argentina, which within a few years of defaulting on its public debt in 2001, fell back into crisis in 2018 due to excessive foreign borrowing and had to seek help from the international community. All this despite the fact that economists had warned that the policies adopted in the years running up to the crisis risked leading the country into a crisis

Attributing blame, for example, for the poor performance of the economy is less relevant when new candidates run for election, who cannot be held accountable for past performance, and who are free to make generous promises about future economic performance in order to win the voters’ favour. Some voters may not give much credence to unbelievable promises made by politicians, but will still vote for those who make the promises that are most pleasing to them. By doing so, they minimize the probability that the promise of some other politician will be carried through. Should the desired politician then win the election, in the worst-case scenario nothing will happen and in the best case some advantage may be gained.

Some might think that in reality politicians are not really interested in increasing economic growth per se, but only in favouring the social groups that support them or, even worse, their close friends. These different objectives are not in conflict. Of course, if I am a politician I can help my friends, but that will hardly be enough to win national elections. A more delicate question is that of favouring certain social groups over others. This typically happens when a government tries to introduce reforms with the aim of increasing the efficiency of the economic system. In doing so, in most cases, it will harm a few specific groups for the wider benefit of the community as a whole. From an electoral point of view, such a strategy may not pay off, because the groups adversely affected may team up to oppose the reform, while the beneficiaries may be widespread and unorganized and therefore politically less active. An alternative strategy might be to favour only certain social groups in order to build their loyalty to the government in office and to be sure of their support for the elections. The difficult part is doing this without harming other social groups as, for given resources, it simply means redistributing from one social group to another.

That is to say, the introduction of unsustainable policies, that is policies that violate the intertemporal budget constraint, inevitably leads to phenomena that restore its validity, even if in an extremely painful way: recessions and devaluations reduce imports and increase exports, leading to a trade surplus, and therefore help to satisfy the external budget constraint with foreign residents; inflation, often driven by currency devaluations, makes it possible to reduce the real value of public debt, effectively imposing a tax on its holders and helping to stabilize its dynamics;* and default is another way to devalue debts and restore the sustainability of the budget constraint.

Often, arriving at a crisis (of sovereign debt or foreign debt) is much more expensive from a social point of view, but it makes the problems “solve themselves”, in the sense that it requires fewer discretionary choices on the part of policy-makers. Strong devaluation with inflation, for example, could be avoided at times, if the central bank raised interest rates significantly. But to do so would be to admit that an unsustainable policy had been conducted in the past and to attract criticism from voters for the decision to raise interest rates that impose costs on citizens. If, on the other hand, there is an exchange rate crisis, the resulting sharp rise in domestic inflation will achieve much of the correction needed to restore and meet the budgetary constraint. The domestic authorities will be able to say that they are not to blame, in the sense that the devaluation and ensuing inflation are not their choice but the result of the actions of some foreign speculator. History is full of such cases.

Although the budgetary constraint of the state is perhaps the most obvious, another important budgetary constraint is the external one. While the state’s budget constraint measures the relationship between the state and the private sector, in the sense, for example, that a state usually has as creditors both domestic residents and citizens of other countries (a country’s government bonds are typically also sold abroad), a nation’s external budget constraint measures a country’s debt and credit relationship with foreign residents. For example, the external budget constraint measures whether a country’s residents, including the public sector, consume foreign goods – i.e. imports, which need to be paid in foreign currency – to a greater extent than foreigners consume domestic goods – i.e. exports, which are mostly sold in foreign currency and are therefore a source of it. If the two amounts are more or less similar, residents as a whole will be able to use export earnings to pay for imports. If, on the other hand, there is an imbalance, for example, residents import more than they export, the excess of imports would create a shortfall of foreign currency and would have to be paid for either by reducing domestic assets held abroad or by borrowing abroad. That is, a resident citizen can use export earnings to pay for imports, or pay with cash kept in foreign currency (for the sake of simplicity, an import from the United States to be paid in dollars), or finally incur a debt (in this example in dollars) to pay for the excess of imports. If there is a persistent imbalance in the foreign accounts, such that a country accumulates a significant level of foreign debt, this will have to be corrected sooner or later to allow the stabilization or repayment of the foreign debt. This basically means being subject to the external budget constraint.

The central bank is an atypical entity because it has the capability of printing money. This might lead you to think that the budgetary constraint does not apply to the central bank. And apparently, there are people who believe this, namely supporters of modern monetary theory (MMT).* After all, a central bank can print as much money as it wants and therefore there is no reason it will ever have to go into debt. But the point is that a central bank needs to maintain a healthy balance sheet in order to be credible in controlling inflation. If there are upward price tensions, central banks have a limited number of options to deploy. They can mop-up liquidity by selling assets, or by paying a high interest rate on banks reserves (commercial banks’ deposit with the central bank) in order to induce them to increase the liquidity deposited with the central bank. In both cases, the asset side of the central bank balance sheet has to be in the position to allow these operations to be sustained, possibly for a prolonged period of time. This implies that, ideally, the asset side has a monetary value close to the liability side (which is mainly comprised by money issued by the central bank) and that the returns on assets are sufficient to pay the high interests on reserves that may be required.

Easy credit enabled families to spend more than their incomes and to get into debt. Had the interest rates on their loans been less favourable, they would have had to devote more of their income to repaying the interest on the loans. Had they not decided to become indebted, they would have had to use a part of their income to pay rent. In both cases, easy credit allowed them to use more of their income for consumption other than housing. Similarly, easy credit allowed construction companies to create numerous construction sites, which, in turn, created demand for the goods needed for construction activity. Overall, this high level of demand from households and construction companies, exceeded the country’s production capacity. That is, at times, households’ demand for consumer goods and investment in construction could not be satisfied by domestic production. When demand exceeds supply, the balance often is restored through an increase in prices.

if there is excess demand, no rise in domestic goods prices and no increase in domestic supply to satisfy that excess demand, the solution is to increase imports. Indeed, the effects of the imbalance was felt in the foreign accounts. The granting of easy credit created two problems. The first was that productive activity was concentrated in the construction industry, which is a sector that produces non-tradable goods. The second was that, as already mentioned, it allowed families to acquire their own homes at low cost and, therefore, allowed them to devote a substantial part of their income to other purchases.

It should be noted that allowing inflation to correct imbalances is easy politically. The ruling party can put the blame for the crisis on foreign financial “speculators” who seek to weaken the economy and bet against the domestic currency. This avoids national politicians having to take any responsibility. There are, however, alternatives, but politically they are more costly. One can raise interest rates and, thus, reduce credit expansion (in the case of Belarus) or one can compensate the effects of easy credit by imposing restrictive policies such as reducing public spending. For the politician or head of government, this can mean backing down and reversing previous policies – in short, admitting to a mistake.

At the end of the 1990s, the US dollar strengthened accompanied by the Argentinian peso, based on the decision to maintain the one-to-one exchange rate. This led to a contraction in exports and contributed to a deep recession. At this point, the CBA’s lack of credibility and the lack of credibility of the Argentinian economic policy authorities more generally, was re-emphasized and took on a decisive role: the expectation grew among Argentinians and the markets that the authorities would not be able to operationalize the restrictive policies necessary to support the currency board and they would decide on a currency devaluation. This triggered a crisis of historic significance. The banks had frequently extended dollar loans to domestic companies whose revenues were in the domestic currency, leaving them unable to repay these dollar loans once the devaluation actually occurred. Bank savers began to withdraw their dollar deposits, fearing that the banks’ dollar reserves might be exhausted and the banks might fail; this triggered capital flight. In short, those able to grab dollars, even if it meant changing pesos into dollars, did so unhesitatingly. The CBA soon ran out of dollars and was forced to abandon the one-to-one exchange rate and let the currency fluctuate. The peso depreciated sharply and all the debts contracted by Argentinians, including the government, with foreigners in dollars, became impossible to repay. Hence, the 2001 Argentinian default on sovereign debt.

Central banks can print new money and add it to their existing stocks if the demand for money grows. For example, demand for money would increase if prices increased, because more money would need to be in circulation to make the same purchases at these higher prices. Similarly, demand for money grows if real national production grows, because there is a need for more money to pay for the increased sales and purchases accompanying higher levels of production. Demand for money grows when the interest rate is low, as the lower the amount of interest paid on other assets, for example government bonds, the higher the investor’s willingness to hold onto money. It increases also during periods of high uncertainty, as agents want to hold liquid assets as a buffer against unexpected events.

But if the amount of new money created is higher than the increased demand for money, agents will not want to hold it and most likely will exchange it for bonds, increasing bond prices and further compressing interest rates, or for other financial assets, inflating their value. It can also happen that some excess liquidity gets spent in consumption, creating some upward price pressure.

All things being equal, if the value of the central bank’s injection of liquidity, let us say the amount credited to the accounts of private banks, exceeds the increased production enabled by the loans made by banks to the private sector, then inflation of goods and services and/or of assets will likely result. That is, if the increase in the means of payment achieved by the granting of the loan by the private bank does not correspond to at least an equal increase in the goods produced, the effect of the loan will weigh on the economy’s purchasing capacity with no corresponding increase in the supply of products.

John Maynard Keynes (1936) taught us that if the economy is not in full employment and there is not full utilization of production potential, even “donated” money can increase national production because it activates additional demand. However, giving away money is certainly not the most efficient way to support the economy, and Keynes did not back this approach. Moreover, whether or not the economy is close to full employment is not something that politicians usually take into account, more often preoccupied by the need to win the approval of voters.

until the end of 2016, Egypt tried to maintain an exchange rate pegged to the dollar. However, to sustain the exchange rate in a situation of a trade balance deficit and, therefore, with a continuous outflow of US dollars, Egypt’s central bank was obliged to meet the demand for dollars. It had to sell dollars and buy Egyptian pounds continually at the fixed exchange rate. Dollars which were bought by Egyptian importers to buy goods from abroad in order to meet the additional demand caused by the growing fiscal deficit, thus closed the circle initiated by public expenditure in deficit. Indeed, the latter pushed up consumption and imports, and in turn increased the need for dollars to meet those imports and led importers to sell local currency in exchange for dollars, thus generating pressures for a currency devaluation.

The dynamics of these crises are simple. As long as credit or fiscal policy is excessively expansionary, citizens can consume more than they produce. This is facilitated by foreign borrowing, which allows these citizens to acquire those imports that fill the gap between demand for goods and services (high) and domestic supply (limited). However, at a certain point this situation becomes unsustainable; investors and foreign governments are no longer willing to grant further loans, which precipitates two responses: (1) repaying the debts incurred, and (2) not taking on any new debt. The latter translates into reducing the trade deficit, by returning domestic demand back to the level of domestic production. This can be achieved by reducing credit or public spending, for instance, but either way implies a retreat from the previous policies. It can be very difficult, politically, to have to admit to the electorate that it is necessary to suspend subsidies and guaranteed public employment because the money has run out. It is admission of a political failure from which few governments would be likely to recover. Moreover, if debt repayments are involved, it may be necessary to go into a trade surplus with foreign countries, which will require achieving an excess of domestic production over consumption, to enable their repayment. In this case, not only must subsidies be removed (and civil servants dismissed), but taxes must be increased. In short, all consumption that exceeded domestic production must be repaid – and with interest. This is when the budgetary constraint re-emerges.

If public expenditure is highly productive, in the example public investment increases income two-fold, then it might be the case that the increase in expenditure pays for itself and that it does not increase the deficit. This is the position taken recently, for example by the IMF, in support of large public investment programmes as a way to support economies out of the pandemic recession (IMF 2020). However, we must exercise caution, as in normal times multipliers of 2 or more are rarely found and are especially rare if the country is highly indebted. This is because the additional expenditure could lead to a further increase in indebtedness, if later it turns out that the investments made were less productive than expected. And history has plenty of examples of investment pushes by the public sector that were less successful than were hoped for, essentially because they cost more money and were less productive than planned. This uncertainty over the outcome of the public investment programme could lead to increases in the risk premium required by investors to hold government bonds and, therefore, in interest rates, which would probably offset the positive impact of the increased spending.

investing in education does not bring immediate benefits in terms of growth and material well-being. Voters, who, among other things, are no longer in receipt of education, may value this type of expenditure less or feel that it does not provide them with any benefit. Thus, these expenses may not be at the top of the politicians’ agendas. It is not surprising that debate often focuses on increasing transfers (pensions, subsidies) and reducing taxes. Rarely a politician’s main campaign message is a promise to spend more on primary schools, or reduce hydro-geological instability, or invest in research.

When the central bank buys government bonds, their seller is paid with newly printed money, which increases the amount of money held by the private sector. To a certain extent, central bank purchase of government bonds can be achieved without increasing this amount, that is, without any “easing” of the monetary conditions. This can be achieved in various ways. For instance, a central bank might first sell off some holdings on the asset side of its balance sheet to make room for government bonds; however, the amounts of these other assets tend to be limited and can include mainly foreign reserves and gold, which does not allow much scope to increase the bank’s government bond holdings. In addition, selling its reserves depletes the central bank of an important asset and will have effects on the exchange rate, typically leading to an appreciation which may be unwelcome. Another possibility would be to buy more government bonds and then try to absorb this additional liquidity by increasing the interest rate paid on banks’ deposits at the central bank, which would provide an incentive to maintain these deposits with the central bank and not lend their liquidity to the economy. However, this possibility could turn out to be very costly for the central bank and is, therefore, not popular. If the return on the asset side of the central bank balance sheet is lower than the interest paid on banks’ deposits, the central bank will run losses and its capital will be depleted. This situation could be maintained for a time without causing a major problem, but could not go on forever.

the large purchase of government bonds carries a risk that the government becomes overstretched and gradually – or in some cases very rapidly – slips into an unsustainable fiscal position. That is, it reaches a level of debt that, under reasonable assumptions, it will be unable to repay in the future. So, what are the consequences? One obvious consequence is that the central bank could suffer a loss in the value of some of its assets, specifically the government bonds, and – if these losses are sufficiently large – its capital will be wiped out. In this case, it would be left with more liabilities than assets, but still able to print money. Nowadays, money is fiat money. Its value is based not on some real asset, such as gold, but on the fact that it is the legal tender that can be used for payments, including tax payments. So, unless one is concerned about inflation and the value of money, there is no reason for not wanting to hold it even if the central bank has negative capital. In other words, one should hold onto one’s money for as long as there are no expectations of inflation or devaluation that would reduce its real value. This then raises the problem that the central bank’s reduced assets might limit its ability to control inflation. If or when it needs to reduce the liquidity in the system, this might require it to sell some assets in exchange for money. If there are insufficient assets on its balance sheet, the central bank might be unable to guarantee full control of inflation. If it tries to reduce the liquidity by increasing the interest rate paid on reserves (banks’ deposits at the central bank), it will likely be forced to run a loss since the returns on the asset side of the balance sheet may fall short of the interest paid on the liability side. These losses will reduce its capital even further and the central bank will not be able to raise finance by printing money because this would contravene its goal of reducing the amount of money in the system. Therefore, the only solution is to sell some assets, but the amount of these is limited and finite, therefore sooner or later the situation will become unsustainable. In this case, it is likely that the central bank will let monetary conditions run loose and choose not to mop up the extra liquidity, in the hope that the monetary stimulus could bring about higher inflation and an increase in the demand for money and, therefore, profits, thereby reinstating its capital.

The indebted entities must reduce expenditure and increase revenue. If increasing revenue (whether from business sales or taxes) is difficult, then all that can be done is contain expenses. However, this implies reducing consumption and investment and, thus, reducing aggregate demand. A reduction in aggregate demand, inevitably, will be accompanied by a reduction in supply and economic activity. In short, a country that wants to contain (and possibly reduce) debt growth in excess of economic activity must accept a certain level of decreased economic growth. The Chinese authorities are sufficiently far-sighted and politically stable to tackle this problem gradually and resolve it within a few years but they will have to accept lower rates of economic growth.

international trade free of constraints can only bring aggregate benefits for all, because each country is free to concentrate its production where it has higher productivity and can produce at lower costs, and import what is not produced at home. It is a matter, merely, of redistributing these benefits to compensate those damaged by free trade. For example, it would not be worth producing steel in Detroit if it was available, at a lower price, from China. If the United States were to spend less on producing steel by buying it from China, it would have more available to spend for example on education, care for the elderly, etc. What matters is ensuring that the steelworkers in Detroit who have lost their jobs are protected (supported financially, relocated, retrained, etc.). This might seem not to be too difficult, but this social support has not been forthcoming.

imposing tariffs on imports does not mean that only foreign producers pay. The intention is to introduce a wedge (the tariff) to increase the domestic price above the one prevailing on the international market. This implies that imports become more expensive than without the tariff and will diminish; domestic producers can increase their production to compensate for the reduced imports. How much domestic production increases, following the imposition of an import duty, depends on how the domestic producers respond to the import price increase. In the US case, if they were to increase their output to satisfy the domestic demand at a competitive price, then, in theory, the domestic price could remain unchanged at the level prevailing in the international market before the introduction of the tariff and domestic output could increase. However, this could not happen; had domestic producers been able to produce large quantities at low prices, there would have been no need to import steel from China. The fact is that US steel is less competitive than Chinese steel and, therefore, the price of the domestically produced steel has to be higher than the international one. Therefore, an increase in domestic prices due to the tariff is inevitable and will weigh on all activities using the goods on which the duty has been imposed.

A budget adjustment can be achieved by either cutting expenses or increasing taxes. If the adjustment occurs during a recession, the most frequent scenario, raising taxes is difficult because people’s incomes are already weakened. Therefore, the choice, usually, is to cut public spending on pensions, public-sector wages, education and healthcare. Acting on these expenditures contains domestic demand, which might be necessary to reduce the trade deficit without weighing directly on productive activities that are needed to support the potential recovery.

More fundamentally, the evidence suggests that, today, wages and inflation react less strongly to domestic economic activity than in the past.* The retail distribution structure is changing as a result of online trade and more intensive use of technology, so the configuration of the margins is changing; value chains are global, so prices are affected less by domestic cost elements; mechanization is increasing and reducing the share of labour in value added while also decreasing the impact of wage developments on prices; and workers’ preferences are shifting towards more flexible and part-time jobs in exchange for more moderate wages. All these factors have kept inflation low.

If independence were to be reconsidered and the central bank became subject to political power with the aim of printing money to meet politicians’ spending needs, it would not be difficult to predict that inflation would immediately emerge. This applies to the case of many emerging economies. In this scenario, in order to contain inflation, it would be necessary to increase real interest rates continuously and, especially where the central bank has poor credibility – as demonstrated in the case of Argentina – to a point where it would also probably cause a recession. Then, high real interest rates combined with recession would change the assessment of debt sustainability. Higher interest expenditure and lower tax revenues, as a result of the recession, would make debt difficult to sustain, lead to investor flight, an increased risk premium and, ultimately, a probable debt crisis. In short, the budget constraint would again regain the upper hand.