Monday, April 29, 2013

Is the Austerity Debate Relevant for Greece?

The debate over austerity has intensified in the past few weeks; this is relevant because folks in Greece will often say that, “research has shown that austerity is bogus, and Greece was just a guinea pig for the wrong idea.” Is that true?

The debate over austerity is, in fact, two overlapping debates—and both debates are mostly irrelevant for Greece. The first debate is whether fiscal consolidation (i.e. cutting spending and raising revenue) can generate economic growth in the short run. The second debate is whether there is a debt threshold after which economic growth takes a sharp hit. (See the end of this article for some references.) Over the past few years, there has been research that supports and rejects both propositions, thus producing highly conflicting messages for policy-makers. What should one make of this research and how does it apply to Greece?

To understand the policy dimensions of this debate, it is important to distinguish between austerity as a precaution and austerity as a last resort. In fact, this is the most important distinction to make and it is one that is seldom made. In the United States and other developed economies there is a debate over austerity as a precaution—a desire to bring order to the country’s balances for fear that without austerity, markets will start questioning the country’s ability to repay its debts. This is the line of reasoning that says “if we don’t balance the budget, we will become another Greece.” But in several European countries, including Greece, austerity was not a precaution but a last resort. Countries chose austerity not because they were afraid that markets would go after them but because markets were going after them.

The inability to separate austerity as a precaution and austerity as a last resort leads to great intellectual confusion. It is the reason why everything that Paul Krugman writes about Greece is irrelevant from the start—he is using an “austerity as a last resort” case to argue about “austerity as a precaution.” Of course, at the continental level, “Europe” is practicing austerity as both a last-resort and a precaution since Germany could in fact bail out the periphery by taking on debt itself (or inducing inflation). The problem is that unlike the United States, where there is a long history of federal-state relations, Europe has no mechanisms by which the debt-assuming core could protect itself against the profligacy of the periphery. So Germany may in fact be practicing “austerity as a precaution” but that is as much a political decision (cannot bail out the profligate periphery) as it is an economic decision (fear of rising interest rates or rising inflation).

To understand whether austerity makes sense in Europe in general and in Greece in particular, we ought to ask “compared to what?” In 2009, Greece’s budget deficit was 15.6% of GDP in 2009—at that point, fiscal consolidation was not an option but a necessity. Academics and policymakers could have a highly interesting debate about whether fiscal consolidation or deficit spending is the appropriate policy during a recession, but that debate would have been irrelevant because Greece could not choose deficit spending—markets refused to lend it money any more. The options facing Greece were different degrees of austerity: either an austerity of the type that the country has followed or a sharper, front-loaded austerity coupled with default, a new currency, higher inflation and other measures that would curtail the country’s standard of living.

The biggest problem with the austerity debate, however, is that it tends to underplay the nuances of each country and each case. It treats two countries with similar macro-economic indicators – budget balance, debt-over-GDP, economic growth, inflation – as similar. They are usually not. How countries got into a position where they require fiscal consolidation matters. There is a slow correction in that regard with more case studies (see the BIS article, for example or the IMF WEO 2012). But the details still get lost in the broader narrative. In my book, Beyond Debt, I explained the perils of this reasoning:

Assume an economy with ten people, each of whom spent €1,000 per month. One morning, a person walks into this economy with a gun and threatens to shoot anyone who spends over €800 a month. Consumption falls by twenty percent. Then, one person disobeys and is killed. With only nine people left, the economy now consumes only €7,200, a 28% decline from its peak. On paper, an economist might look at this economy and think it needs a monetary stimulus through lower interest rates. Or, the economist could say that the government should step in and support consumption directly since private consumers are not consuming. Of course, both suggestions would be absurd—what the country needs is someone to stop the guy with the gun. A Keynesian stimulus in an economy with underlying ailments is akin to trying to heat a room with an open window—the heat will help, but best to close the window first (pp. 84—85).

In the case of Greece, for example, arguing that the country would benefit from deficit spending is lubricous (even if it were possible, which it is not). When the recession started in 2008, real primary spending grew by 6.8%; in 2009, as the recession deepened, it grew by another 4.9%. In other words, the economy got a government stimulus of about +16% and yet the economy fell into recession. It would be hard to argue that in the 2006—2009, when the size of the state grew by a fifth, the problem with the Greek economy was insufficient government spending. The opposite was true.

Nor does one get a complete picture of “austerity policies” by merely looking at the headline figures. As I have written in the past, Greece’s policies are anything but austerity (see here, here, here, and here). Even in 2012, spending on government wages was barely below its 2010 levels as a share of GDP and considerably above what it was in the period from 2000 to 2007. Spending on social benefits reached (again) a historical high, and no, this is not because of generous unemployment benefits. Structural reforms, on which any fiscal consolidation really depends, have lagged and effectively stalled. In that environment, it is hard to create growth and it is hard to convince investors to lend you money because they see that you are not serious about cutting your deficit.

In sum, diagnostics matter. Details matter. The research on austerity can yield some insights but most of these are not very applicable to Greece’s case. Greece’s problems are painfully banal and they don’t need cutting edge to diagnose or cure. They require common sense and political courage. No amount of research can change that elementary fact. 
 
References

BBC, “The mysterious powers of Microsoft Excel,” April 20, 2013, http://www.bbc.co.uk/news/magazine-22213219

Harvard Business Review, “Austerity’s Big Bait-and-Switch,” April 11, 2013, http://blogs.hbr.org/ideacast/2013/04/austeritys-big-bait-and-switch.html

International Monetary Fund, “Chapter 3: Will It Hurt? Macroeconomic Effects of Fiscal Consolidation,” World Economic Outlook, October 2010, http://www.imf.org/external/pubs/ft/weo/2010/02/pdf/c3.pdf

International Monetary Fund, “Chapter 3: The Good the Bad, and the Ugly: 100 years of dealing with public debt overhangs,” World Economic Outlook, October 2012, http://www.imf.org/external/pubs/ft/weo/2012/02/pdf/c3.pdf

Krugman, Paul. “The 1 Percent’s Solution,” New York Times, April 25, 2013,

Perotti, Roberto, “The ‘Austerity’ Myth: Gain without Pain?” BIS Working Papers, No 362, November 2011, http://www.bis.org/publ/work362.pdf 

Pollin, Robert and Ash, Michael, “Austerity After Reinhart and Rogoff,” Financial Times, April 17, 2013, http://www.ft.com/intl/cms/s/0/9e5107f8-a75c-11e2-9fbe-00144feabdc0.html

Reinhart, Carmen and Rogoff, Kenneth, “Debt, Growth and the Austerity Debate,” New York Times, April, 25. 2013, http://www.nytimes.com/2013/04/26/opinion/debt-growth-and-the-austerity-debate.html

Reinhart, Carmen and Rogoff, Kenneth, “Responding to our critics,” New York Times, April, 25. 2013,

4 comments:

  1. I am afraid that Greece is not so much an economic case than a moral one. Austerity as a means to achieve a balanced budget is not the issue here (at least not yet). The issue is stopping the outrageous waste of public money and the very common attitude that the state is there to be robbed by its citizens.

    And because this sickness is still not addressed the Eurozone partners find it increasingly difficult to justify supporting Greece. They cannot see much progress in the direction of Greece becoming a modern country where citizens and state have a fair deal: I pay my taxes and you deliver me services that make my life and society at large better.

    The depressing aspect is that this kind of mentality change takes generations. Time that Greece does not have. My expectation is that something will soon have to give: Either Greece collapses and can no longer stay in the Euro or even the EU or Germany will more or less dynamically build a northern EU grouping with the partners that share its understanding of fiscal and economic governance.

    What I cannot see is a permanent transfer union from the north to the south in the absence of a common democractic system. Nobody will seriously believe that the German or Dutch taxpayer will ever have a direct say in Greek politics (or even aspire to such participation).

    ReplyDelete
  2. Nikos,

    As usual you put things in the proper perspective. Distinguishing between austerity as a precaution and as a necessity is lost in the usual media discussion and debate between pro- and anti-austerity supporters, for Greece and other countries. People feel they must give un-nuanced explanations or take unbalanced positions. Above all else, they feel they need to selectively use statistics to prove their point. If that doesn't work, then throw some mud at the other guy as a last resort. I hope some Greek newspapers pick up your article, but somehow I doubt it.

    Regards,

    George

    ReplyDelete
  3. Robert MarchenoirMay 4, 2013 at 12:14 PM

    "A Keynesian stimulus in an economy with underlying ailments is akin to trying to heat a room with an open window—the heat will help, but best to close the window first."

    Why is it that such common-sense remarks are usually lacking in economists' thinking ?

    ReplyDelete
  4. Robert MarchenoirMay 4, 2013 at 12:16 PM

    "I am afraid that Greece is not so much an economic case than a moral one."

    This Frenchman can tell you that the same applies to his country.

    ReplyDelete

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