The commonly accepted policy hypothesis is that austerity might have expansionary effects, because the expectations that today’s sacrifices will translate into tax reductions and higher disposable income in the future might induce economic agents to increase consumption and investment in the short term. Another common defense of current austerity programs is the risk that bond markets, whenever a government is not sufficiently committed to budget balance, may demand huge spreads for sovereign debt and possibly push a nation into default. The question of whether fiscal consolidation may have expansionary effects is a relevant policy issue as the emerging empirical evidence is actually contradicting the tale of expansionary austerity. Economies under austerity programs are experiencing a second severe contraction of economic activity, following the one that already occurred in 2008-09; in addition, bond yields of peripheral Eurozone countries, which, unlike the United Kingdom, cannot devaluate their currency, are at levels which are not sustainable at the present negative growth rates. Indeed, historical evidence tells us that expansionary effects of austerity measures are rarely observed (Guajardo et al. 2011); in particular, they occurred only when austerity measures were implemented in an international setting where trade partners were flourishing. Fiscal austerity was typically combined with a mix of internal and external devaluation that resulted in sinking real wages and prices with respect to the trade partners. Due to lower relative prices, the competitive position of these countries in international trade became better, the current account position increased and, due to increased exports and/or decreased imports, both the economy and the government budget recovered. On the contrary, in the current situation, where government spending decreases and/ or taxes rise, i.e., demand from the government and disposable private income decrease, none of the major centers of economic activity – Europe, the United States and China – is willing to accept substantially lower exports and/or higher imports. As all current accounts must sum up to zero by definition, the attempt to improve, e.g. by external devaluation, all current accounts simultaneously just gives rise to a beggar-thy-neighbor policy in which no one will eventually be able to attain this goal. The same logic also holds of course for the economies within the Eurozone, where indeed internal devaluation is the main policy available. Furthermore, following the asset bubble burst, most European economies

(as well as the United Kingdom and United States) are now in an economic scenario where the over-indebted private sector is trying to deleverage its balance sheets and financial institutions are unwilling to lend because they also need to strengthen their balance sheets and face a shortage of willing and creditworthy borrowers. This deleveraging of the private sector reduces aggregate demand, due to both lower consumption and investments, and throws the economy into a very special type of recession which has been named as balance-sheet recession (Koo 2009, 2011). In such a scenario, monetary policy, the traditional remedy to recessions, is ineffective because the private sector is unwilling to increase borrowing, even at very low interest rates; and unconventional monetary measures boosting base money, like quantitative easing, are scarcely effective to increase the broad money supply and then sustain the economy. The money supply may actually contract, because the private sector collectively draws down bank deposits to repay debts. In the absence of new economic players borrowing and spending money, the economy enters a deflationary spiral where demand is continuously reduced by net debt repayments. In such a scenario, it is argued that the public sector should actually move in the opposite direction to offset private sector deleveraging, i.e., perform a deficit-financed fiscal stimulus aimed to maintain incomes of businesses and households and allow balance-sheet repair without forcing the economy into depression. Government borrowing should not encounter much difficulty in a balance-sheet recession, unlike in a dysfunctional monetary union (Wolf 2012), due to the availability of savings in excess from the private sector, low interest rates and high risk aversion. Moreover, recent studies (see, e.g., DeLong and Summers 2012) have provided convincing theoretical and empirical evidence about the efficacy of temporary expansionary fiscal policy in severely depressed economies. First, the absence of supply constraints and low interest rates makes the fiscal multiplier substantially greater than in normal times. Second, preventing prolonged output shortfalls though a deficit-financed fiscal stimulus may ease rather than jeopardize the long-run government budget constraint because of hysteresis effects of present output drops on the economy’s future potential, through the decrease of investments and the increase of structural unemployment. In a balance-sheet recession as well as in a severe depression scenario, like the one faced now by most Western economies, fiscal stimulus could actually turn out to be expansionary and self-financing while fiscal austerity may turn out to be depressive and self-defeating. The research questions we aim to address concern the role of fiscal policy combined with monetary expansion (quantitative easing) in different economic scenarios, characterized by a higher or lower vulnerability to balance-sheet recessions. In previous works (see Raberto et al. 2012; Teglio et al. 2012) we have shown that the economic system is more vulnerable when the amount of credit money injected in the system becomes too high. We have shown that excessive banks’ leverage, due to permissive banking regulation, significantly reduces economic stability, increasing the probability of financial crises and economic recessions. In this chapter we investigate the effect of a combination

of fiscal and monetary policy according to different fragility levels of the economic system. In particular, we aim to understand whether a regime of quantitative easing mixed with fiscal expansion (tax reduction) can be successful in weakening the impact of economic crises without deteriorating deficit and debt of the public sector in the medium to long run.