Monday, January 23, 2012

Is Austerity All that Bad?

Austerity is a bad word these days. Economists and politicians blame the austerity cocktail imposed on Europe’s periphery for the continent’s woes; the insistence on cutting government spending, they say, illustrates the wrong-headedness of the Washington Consensus and of Berlin who focus on deficits and debt when they should be focusing on economic growth. But austerity is not all bad - and the press for structural reform is precisely what Europe needs.

The case against austerity rests on a Keynesian argument. Effective demand is low during a recession, and the economy may equilibrate at an employment level below its full potential. Keynes argued that the process through which an economy bounces back – chiefly, wages falling to induce more workers to work – does not work very smoothly. An economy can get stuck as a result. A government can create demand through deficit spending; by putting money into people’s pockets, it can accelerate the recovery and help make smoother the business cycle.

The problem is that the Keynesian recipe of deficit spending is diagnostically neutral. It starts from an observation (low demand) but it does not investigate its root causes. Take an extreme example: assume that a country imposes a 50% tax on all goods and services. Consumption will plummet. A Keynesian might recommend that the state step in and buttress demand with deficit spending. Such spending will no doubt support the economy – the recession will be milder, and the economy may even grow. But in this (simplistic) scenario, the solution of more government spending is absurdly inefficient. Why not simply eliminate the tax? Keynesianism in a flawed economy is like heating a room with an open window: the heat will warm you but close the window first!

Whether an economy should apply a stimulus does not depend on whether such spending will create short-term demand and help the economy – it will. Instead, it depends on whether such recipe addresses the economy’s weaknesses. You cannot resolve microeconomic ailments through macroeconomics: Keynesians retort that growth is what matters – growth cures debt, for example, since countries tend grow out of their debt problems. So long as you can produce growth, you can cure many ills.

This is where the Keynesian argument loses steam. There is, of course, a question of whether government stimulus in fact generates long-term growth – although I have no intention to get into that debate. Instead, my view is that a recession is exactly the right time to make structural economic changes, especially when a country needs to reduce the footprint of the state and to revitalize the private sector through competition. Countries that managed to shrink the state did so after prolonged recessions or slumps: the United States, the United Kingdom, Ireland, Sweden, Finland, the Netherlands, Belgium and many others. Growth rarely favors reforms, especially in the form of a reduced state sector.

Keynesianism presumes that there are two courses: an austerity-driven recession or a deficit-driven expansion. But that’s a false dichotomy. Austerity can produce growth – in Greece’s case, the problem is that state spending is not falling quickly enough and, as a result, the state keeps raising taxes which, in turn, reduce consumption. It is not that austerity is causing the recession; rather, the issue is that austerity is not happening rapidly enough. More generally policymakers can either treat the symptom or the disease: for the most part, deficit spending is aimed at the symptoms. And like other policies that focus on symptoms – debt rescheduling or exit from the Eurozone – they miss the point and should be ignored.

22 comments:

  1. ...And?

    All the aformentioned countries have an efficient and productive private sector...I'm afraid,Niko,austerity for a service-oriented economy like Greece results only in savage contraction of GDP.I'm not even sure this recipe is meant to work anyway...

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  2. I absolutely agree with Niko. Structural reforms is the only way out of the existing situation, whitch clearly is inefficent. If one could carry out reforms without austerity, then that would be the most effective way. Unfortunately, getting rid of ineffectivness itself is austerity.

    In Greek case, I feel you've got it all wrong. The only thing government has been able to do, are tax hikes, without radical austerity in public sector expences, where its really needed.

    The future of Greece? From thousonds of kilometers away I feel, that you have basically two options, to put it simple. The first and most likely scenario is, that you continue with your current political, business etc culture, and therefore have to reduce your average living standard remarkably. (You will probably never achieve the standard, that you had during mid 2000-s.) But maybe its not that bad afterall. Its not taht youa are going to starve or smth, you just have to drive Romanian cars instead of German ones, but so what. The other option is very tough. You'd have to change as a nation in general, whitch might grant you a higher living standard. And that means huge changes in work ethics, humility, decision making and so on, so on. So, to live like a germans, you need to have culture similar to theirs, whitch is a high price to pay. A night out in Frankfurt is a really dull one. So perhaps you should not worry to much and continue just beeing greeks, because thats not going to change anyway.

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  3. The salary and pension cuts imposed in Greece were twice as high as the ones in Ireland and Portugal and DEKO/public sector workers expect more reductions to come.So please ease off the stereotyping,Martin.

    The truth is that Greece exports very little and right now everyone is(understandably)too scared to invest their money here.The Greek state should press on with privatizations and make the country more friendly to investments.

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  4. Estonian Minister of Finance said today in a press conference "greeks are not lazy, but overpaid", and I agree with him. High salaries, pensions, too high minimum wage etc, etc are among the reasons your economy is not competitive. You just cant export, if prices of your products are too high, to put it very simple. If cuts twice the amount of Ireland are not enough, then they are simply not enough. Greek budget must break even in long run and cuts already made are not enough. Even if you were debt free, you would still not break even. Rather simple case.. from that point of view.

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  5. Not that simple.When the state gathers less revenue(a by-product of austerity),it has no hope of balancing its budget.Overwhelming tax hikes and cuts came,civil servants and even private sector workers got fired,unemployment hit 18,5% and the result...was a recession reaching 7%.

    If Greece can return to growth by reducing the labour cost,then go ahead.I'm just not sure whether it can yield positive results.

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  6. I agree, that the tax hikes don't support the growth and should be avoided by any means, if possible. On the other hand, you have to cover public expenses, which doesn't mean you have to rise taxes, you can also reduce spending by lowering salaries/pensions and/or reducing jobs (austerity). In Greece case, also very fundamental changes are needed in structure of economy, education etc (these are not needed in Ireland, for example). But still, at the high level it is simple. On the long term you can spend only what you earn, and if your economy is so uncompetitive, that it can export only "sea and sun", then you have to change something or accept lower living standard. Which is also a choice and not necessarily a bad one.

    My country (Estonia) chose a very tough way of overcoming crisis. We had our local crisis + global financial crisis six monts after a local one. Government chose austerity, tax hikes were minimal, income of public sector fell 20%, unempl0yment rate was about 17%, GDP fell by ~15%. They also changed Labor law, so that it would be very easy to hire and fire people (special fund for unemployed, very small risk for employer). 2011 we got GDP rise of 8+ % unemployment rate 10%, export growth was about 30% if i remeber correctly. It was really painful, but now, when the pain is mostly over, we are in much stronger position, than before the crisis. We don't have big public sector debt (7%) and therefore we can afford rather low taxes. And our government was re-elected! I personally suffered 15% salary drop and accepted it as necessary measure. I'm not trying to blame you for your inability to reform by telling how perfect we are. We are not and we do hanve a lot of problems. It's just an example, how austerity actually has worked miracles.

    Austerity is tough, structural reforms are tough. But if you can handle the suffering then maybe (just maybe) it is followed by rewards. The other choice, as I mentioned in my first post, is Romanian cars instead of German ones. But these Dacias are actually quite shite, if you ask me.

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    1. I didn't see the reply button

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  7. @ Martin: I fully agree with your comments. The development in Estonia is actually very interesting, it is a "best practice" you should be proud of. A major difference to Greece is that your politicians are capable and reliable and willing to value the country's well-being higher than their own wealth (as a result, e.g. cutting their own salaries and privileges first). They are down-to-earth. Culture does obviously also play a major role. For everyone interested in the Estonian case, you are welcome to read the following article:

    http://www.spiegel.de/international/0,1518,790293,00.html

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  8. Austerity could not work in the same way it worked for Estonia.It unlike Greece didn't have a high public debt during the period of adjustment,whereas Greece is on the verge of insolvency every three months and the fact that GDP contracts with each passing day is making things much worse.I think,Martin,while we Greeks(especially our political leaders)have much to learn from you Estonians,our situation is more akin to Latin America and Niger rather than yours.I'd say,if only we did have the same problems Estonia had.

    And bear in mind that austerity is not guaranted to deliver always,just look at your neighbour Latvia,where knee-bending austerity drove the country to mayhem.Greece has lost 20% of its GDP since 2008 and is expected to lose more...It's becoming more and more obvious that Europe lacks a pro-growth strategy it desperately needs amidst the crisis.

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    1. Greece is already de facto insolvent. It lives from foreign aid because nobody else wants to lend money to it besides European governments that are forced to fulfill the role of aid organizations. The opposite of austerity means to spend even more of other people's money, but no government is crazy enough to lend more money to Greece if you don't tighten your belts to a degree that makes you competitive again. The reason why austerity fails so far is that it is not accompanied by the necessary structural reforms. Maybe you should read Nico's blog more carefully. The Swedish finance minister said today about Greece "I have never ever seen an IMF program which is so much off track in my life" and you have to ask your politicians why they fail. Samaras seems to sabotage reforms because he thinks he can profit from that.

      One problem that people like you have is that you don't recognize or acknowledge these problems and that you have a biased, counter-productive sense of "fairness". You seem to forget e.g. that Greece has still less unemployment and higher minimum wages than Spain, but Spainiards need to bail you out and don't complain so much about austerity. Estonians earn on average less than Greeks and need to bail you out. You should only earn what you deserve and not spend more than you earn. At the moment the Greek economy is so unproductive that you should earn less and/or increase the output, become more competitive. The first step forward would be to understand that, and to understand the right to spend other people's money forever doesn't exist.

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    2. Are you out of your mind?What's this "sense of fairness" you're talking about?The purpose of these rescue packages are to help Greece stand on its own feet again and of course the people will have to adjust to painful reforms for that to happen.But do tell me,how much effort has been put by both the IMF and the Greek government into creating a fair and efficient tax collecting system?How many investments have been proposed recently?Cutting the GDP to such degree alone isn't the answer and it's ironic how you call my opinions counter-productive,when governments around the world are doing nothing to reduce unemployment.Of course Greece can't carry on running structural deficits,but you NEED pro-growth solutions to counter-balance loss of consumption which is a result of austerity.As I mentioned above Greece has lost a total 20% of its economy because of the stop-gap measures enacted to a large extent.How do you expect the country to balance its budget when you force it to recieve less?For the record,know that it's not just the leader of the opposition that objects to further cuts,the Association of Greek Industrialists agree that more reductions will harm the economy.What the country needs the most is a more liberal approach to development,all these tax code fluctuations do no good.And like I said,if lower wages do bring growth,take it away and reduce living standards.My concern however is how many more small and medium-sized businesses will have to close down as a consequence.Thousands have since 2009...If full-scale deflation is Europe's answer to the crisis,then let the country declare bankruptcy,as it will never find the revenue to pay its debts.And yes,Estonia is one example,but Latvia and Brazil are another.Perhaps now that Portugal is preparing to apply for a second bail-out,Europeans will come to terms with the fact that they are offering no viable solution to the problem.

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    3. And let's not forget how much crime rate and shadow economy have grown since the austerity measures were applied...

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    4. As I said, you don't recognize the problem yet. Greece has huge negative trade imbalances, it has to decrease imports and/or increase exports, but for the latter you it must become more competitive, and too high labour costs are a part of the problem. Moreover, Greece must implement structural reforms so that it can grow again, but your government is completely off track and massively criticized for that. Because without structural reforms (liberalization of markets and labour laws, streamlining bureaucracy, improving the opportunity to sue tax frauds etc.) it will never attract foreign investments, never break monopolistic market structures, never create new jobs and will never grow. These reforms do not create significant costs, and most is paid by the EU anyway (e.g. the "task force" which is teaching public servants). And Greece needs spending cuts especially in the public sector, but liberalization reforms in the private one. Why Greek politicians are killing the private sector with silly tax hikes is something you have to ask them. Not austerity is killing your economy but the lack of reforms.

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  9. Selene, maybe this helps you to get a clearer picture:

    http://www.economist.com/node/21543536

    Actually you should already have a clearer picture after reading this excellent blogg.

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  10. Considering that Greece does not want to see its future in the monetary union tainted and seeing that the Euro has become almost exclusively a German currency and Germany alone dictates what happens,I sincerely wish that you are right.I'm not contesting that more structural reforms are necessary per se and the need to shrink the government(preferrably through privatizations)is in turn necessary to cleanse the public sector of corruption.Will that be enough,though?Assuming we even decrease the minimum wage in the private sector,will young Greeks find themselves employed?The Euro provides no flexibility in its current shape and no-one is inclined to invest their money in the South...

    I think these reforms could have been more effective if they had been implemented between 1999 and 2001 the year before Greece joined the Euro.

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    1. The Euro is not a German currency, it is a stable "hard currency" and was ment to be one from the beginning. That's the reason why esp. southern European governments went over bodies to be able to join it in the 90s because they had problems with high inflation, hence high interest rates for bonds and permanent devaluations, destroying a lot of wealth and hindering investments. This blog offers an interesting chart, showing these old problems.

      But you are right, it would have been better if Greece had first diversified and modernized its economy and implemented structural reforms and joined the Euro later. Like Estonia did for example. But ask yourself: Is that realistic? Would the Greek political class have become more efficient and less selfish and would it have stopped serving the interests of certain lobbies if there was the chance to simply devalue the currency, which basically means sweeping fundamental problems under the carpet? Is the current crisis not also a chance for your country to modernize very fast, getting all the external technical assistence (e.g. modernization of tax system, land register etc.)? Is it not a chance to integrate Europe a bit further? I just wish it wouldn't hit the average Greek so hard.

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    2. No,I definetely wouldn't want Greece to keep printing money to fund its debts like it did in the past and the UK and the US are doing now to supply their deficits.Nonetheless,deflation and GDP contraction alone will never bring positive results when an economy lies stagnated,liquidity is missing,exports are few,public debt and borrowing costs rise and the risk of contagion looms.So a small drop in the value of the currency could inspire some hope for economic growth in troubled countries like Italy.Germany could loosen its intransigence regarding this.

      We are both in agreement I believe that Greece needs 1)to build a proper tax system,2)to eliminate corruption in the public sector and 3)to focus on re-inforcing its private sector.The funny thing is that excluding national insurance contributions the minimum wage in the private sector is approximately 580 Euros,not 800(220 Euros are taxed!).Hence why I don't understand what this talk of overpaid workers is about,when the sluggish procedures and regulations are what leeching capital out of the country...

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    3. You are defenitelly right, sluggish procedures and regulations are the biggest cost factor. The talk about "overpaid workers" concerns the public sector, doesn't it? Whether or not the minimum wage is too high depends on the labour market situation, and it is a matter of fact that it can avoid employment. From my point of view one should judge a minimum wage depending on the payment "per hour" to avoid exploitation, not "per month". Because a lower minimum wage could make sense e.g. for half-time jobs, and a government should fill up the gap with financial support if the job alone is not enough to survive. That's a win-win. In general, salaries should depend on success, be more flexible and not be decided centrally.

      The German government has no influence on ECB decisions, but it is more or less successfully defending the bank's independence to avoid that governments "printing money to fund its debts like it did in the past." Such a decision should come from Mario Draghi and nobody else. And you'll see that the bank will "print" much more this year than it already did, and maybe 2013 as well to fight deflation and credit crunches.

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  11. Actually it seems that even the Troika admitted that the austerity plan is not working, check it here:
    http://www.creditwritedowns.com/2011/10/greece-expansionary-fiscal-consolidation-failure.html
    and here:
    http://digitaljournal.com/article/319115

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  12. Greece needs to leave the Euro ASAP otherwise it will be stripped of it's assets. Austerity can't work, if you want people to start spending money you need to give them money to kick start the economy not take it away. Greece depends on tourism and this is down due to, World Wide economic situation and also the prices have been forced up. Greece is in a downward death spiral, I see a revolution if things don't change in the next month or two.

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  13. I do not agree whatsoever with your conclusions--
    1) That more activities are needed to keep tourists in Greece for longer stays. The pollution, marked inconvenience (not only due to strikes) and the rudeness of those in tourism are reasons why tourists curtail their visits. Unlike other countries who embrace tourists, Greeks obviously disdain them.
    2) That Greece needs to attract higher paying tourists. Tourists are constantly barraged w/ price gouging. Incessant price gouging tires the tourist and makes him distrustful and less likely to spend money.

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    1. apologies-- the comment was meant for the disappointing tourism numbers in Greece

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