A stable macroeconomic environment does not drive economic growth, but it is a necessary condition to promote productivity.29 Uncertainty about the future economic outlook, associated with volatile inflation and doubts about the sustainability of public finances or recessions caused by financial crises, can dramatically reduce investments. Fischer (1993) defines a stable macroeconomic framework as being characterized by low and predictable inflation and sustainable fiscal policy,30 and shows that both these factors increase capital accumulation and productivity growth. Recent financial crises have brought to light additional factors affecting the stability of the economic environment: the composition of public finance, its dynamic interaction with the financial sector, and the detrimental effect of recessions resulting from financial meltdown.
The first ingredient for a stable macroeconomic environment is low inflation. In principle it is volatility of prices that affects productivity rather than high levels of inflation per se, but empirical research has found that in practice high levels of inflation are by nature volatile.31 When inflation is high, future prices are less certain so returns are less predictable and long-term projects become riskier, reducing the willingness of firms and investors to invest. Deflation or near-zero inflation also has negative effects on the economy: it increases the real value of debt; it may also generate unemployment, because wages remain artificially above market level; it discourages investment by increasing real interest rates; and it can lead to a self-reinforcing cycle of consumers holding back spending in expectation of further price decreases. For these reasons, most central banks target moderate and stable inflation.
The second component of macroeconomic stability is the avoidance of uncertainty about public finances.32 Such uncertainty may cause potential investors to hold back from committing to new projects,33 or to prefer short-term projects to longer-term ones that would have higher returns and more impact on productivity growth.34 The need to deal with high public debt may also diminish a government’s effective political independence, including its flexibility to pursue policies that would promote productivity-enhancing investments.35 If governments increase taxes to service the debt, this can introduce market distortions that affect productivity.36 On the other hand, if governments borrow to service the debt, they need to offer higher interest rates to compensate for perceived higher risk, which can crowd out private investment.
In addition, some studies suggest that the composition of debt may matter: Gros (2011) argues that public debt owed to foreigners is much riskier than domestic public debt, because governments cannot tax non-citizens. Debt owed in foreign currency also exposes a country to the risk that depreciating exchange rates will add to the debt burden.37 Higher interest rate spreads on foreign currency debt amplify the crowding out effect.38
With respect to foreign currency exposure, private debt can also have destabilizing effects on the economy: countries whose firms hold a large amount of foreign currency–denominated debt may run the risk of a crisis since sudden stops and currency volatility can produce a chain of private-sector defaults.39
When countries with high levels of public debt run budget deficits, this fuels perceptions of instability by indicating that unsustainable debt levels will be reached at a faster rate.40 The recent financial crisis has highlighted that concerns about the unsustainability of public debt can be self-reinforcing:41 high public debt forces up interest rates, making it more difficult for governments to service the debt, which adds to concerns about the debt’s unsustainability.
The second lesson from the recent recession is that financial crises, although originating in the financial sector, can have macroeconomic effects, generating an unstable economic outlook. Recessions associated with financial crises can harm long-term productivity through a phenomenon called hysteresis, which may explain why the global economy failed to return to previous levels of growth after the crisis.42 Financial crises cause banks to restrict credit, reducing investment and increasing unemployment.43 Before credit lines can be re-established some firms go bankrupt, losing intangible assets, while unemployed workers lose skills.