Thursday, November 27, 2014

Austerity under Attack

BRUSSELS – Europe seems to be obsessed with austerity. Country after country is being forced by either the financial markets or the European Union to start cutting its public-sector deficit. And, as if this were not enough, 25 of the 27 EU member states have just agreed on a new treaty (called a “fiscal compact”) that would oblige them never to have a cyclically adjusted budget deficit of more than 0.5% of GDP. (For comparison, the United States’ budget deficit in 2011 was close to 8% of GDP).

But, as the European economy risks falling into recession, many observers are asking whether “austerity” could be self-defeating. Could a reduction in government expenditure (or an increase in taxes) lead to such a sharp decline in economic activity that revenues fall and the fiscal position actually deteriorates further?

This is highly unlikely, given the way our economies work. Moreover, if it were true, it would follow that tax cuts would reduce budget deficits, because faster economic growth would generate higher revenues, even at lower tax rates. This proposition has been tested several times in the US, where tax cuts were invariably followed by higher deficits.

In Europe, the concern today is instead with the debt/GDP ratio. The worry here is that the GDP drop resulting from “austerity” might be so large that the debt ratio increases. This matters, because investors often use the debt ratio as an indicator of financial sustainability. Thus, a lower deficit might actually heighten tensions in financial markets.

However, a lower deficit must lead over time to a lower debt ratio, even if this ratio worsens in the short run. After all, most models used to assess the economic impact of fiscal policy imply that a cut in expenditure, for example, lowers demand in the short run, but that the economy recovers after a while to its previous level. So, in the long run, fiscal policy has no lasting impact (or only a very small one) on output. This implies that whatever short-run negative impact lower demand may have on the debt ratio should be offset later (in the medium to long run) by the rebound in demand that brings the economy back to its previous output level.

Moreover, even assuming that the impact of a permanent cut in public expenditure on demand and output is also permanent, the GDP reduction remains a one-off phenomenon, whereas the lower deficit continues to have a positive impact on the debt level year after year.

Notice that this conclusion was reached without any recourse to what Paul Krugman and others have derided as the “confidence fairy.” In the US, it might indeed be unreasonable to expect that a lower deficit translates into a lower risk premium – for the simple reason that the US government pays already ultra-low interest rates.

But, even without any confidence effects, the bipartisan Congressional Budget Office has concluded that, while cutting the US deficit does lower demand, it still leads reliably to a lower debt ratio. This should be all the more true for eurozone countries, like Italy or Spain, that are now paying risk premia in excess of 3-4%. For these countries, the confidence fairy has become a monster.

The decisive question then becomes: What matters more, the impact of deficit cutting on the debt/GDP ratio in the short run or in the long run?

Prospective buyers of Italian ten-year bonds should look at the longer-term impact of deficit cutting on the debt level, which is pretty certain to be positive. Of course, some market participants might not be rational, demanding a higher risk premium following a short-term deterioration of the debt ratio. But those concentrating on the short term risk losing money, because the risk premium will eventually decline when the debt ratio turns around.

Abandoning austerity out of fear that financial markets might be short-sighted would only postpone the day of reckoning, because debt ratios would increase in the long run. Moreover, it is highly unlikely that Italy, for example, would pay a lower risk premium if it ran larger deficits.

It would be dangerous for the eurozone’s highly indebted countries to abandon austerity now. Any country that enters a period of heightened risk aversion with a large debt overhang faces only bad choices. Implementing credible austerity plans constitutes the lesser evil, even if this aggravates the cyclical downturn in the short run.

Read more from our "Austerity and its Discontents" Focal Point.

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    1. CommentedShane Beck

      Yeah, yeah we get that austerity and lower deficits in the long run is good for the state and foreign bondholders, but can countries really cope with the side effects such as 50% youth unemployment and 25% general unemployment in nations such as Spain and Greece? Such statistics are not conducive to the stability of the country in the short term, which is what really matters.....

    2. CommentedStamatis Kavvadias

      "Could a reduction in government expenditure (or an increase in taxes) lead to such a sharp decline in economic activity that revenues fall and the fiscal position actually deteriorates further?
      This is highly unlikely, given the way our economies work."
      And then the author asks the reverese...

      What economists seem not to understand (but are more likely not willing to understand because of "ideology"?) is that this all depends. First, "the way our economies work" is not the same across Europe, and in some countries the economy benefits the most from small businesses, where in others large businesses make the difference.

      Second, and most importand, not all tax increases are equal, with respect to their impact in the economy!!! When a country mostly has small businesses, the impact of heavy taxation on the lower side of the income scale is devastating, and the economy has no real chance of recovery, because, well, there probably was a reason it was not mostly based on large businesses and large capital consentration! Assuming that the whole orientation of the economy must change, is actually a very high-risk bet. The reverse would also be true. If taxation was heavy in the high-income side of the scale, in an economy largely growing from big business revenues, the economy would not have a real chance of getting in a sustainable path, both because small businesses would have a very difficult time replenish the difference, and beacause of large business and capital flight. (This would rearly be the case, though, because large businesses usually have big influence in governments.)

      These seem to be true, after four years of austerity, for most European countries. Of course, there are other factors in this tradeoff that are also important. In some few cases, the spread of income at the top and the bottom sides of the scale is not very big, where in other this spread is wide. The former have less likelihood of being troubled by the above conundrum, as uniform changes in taxation are more easily be accepted and bring results. Also, there are cases of large income other than large business revenues, and it is very importand whether large incomes are spent domestically, versus being spent abroad or become savings...

      In all cases, there is no single "way our economies work" across Europe, and thus deficits are not likely to decline with policies aimed only at austerity, without balance of taxation related to the target economy , and the rest of the discussion on debt levels is baseless.

      The whole "ideological" thrust behind unguided austerity, is highly unlikely to work, especially in economies based on many small businesses, that have no political leverage. The idea of boxing European economies to fit the dimensions and wealth-spread of the German economy is very naive and untrained. This is especially true in the current downturn of the global economy, where a failed financial system cannot spur a race of big business competion, as it did before 2007. The illustration of Tim Brinton, in this article, is obiviously demonstrative of what normal people can see clearly, but is a mistery to preconditioned European economists!

    3. Commentedparthasarathy Shakkottai

      The answer depends on whether the country is monetarily sovereign or not. For USA debt/GDP does not matter because govt debt is nothing but private sector savings. Only deficits grow the economy.
      For Greece which is not sovereign in euro there is no solution. It has to put up with austerity or get out of the euro-zone and gets its democracy back. The standard of living will go down in either case.