Saturday, November 29, 2014

Europe’s Irrelevant Austerity Debate

BRUSSELS – The most visible symptom of the crisis in the eurozone has been the high and variable risk premiums that its peripheral countries now must pay on their public debt. Moreover, an influential paper by the American economists Carmen Reinhart and Kenneth Rogoff suggests that economic growth falls sharply when a country’s public debt rises above 90% of GDP. So the policy prescription for solving the crisis seems simple: austerity. Fiscal deficits must be cut to reduce debt levels.

But the debate about austerity and the cost of high public-debt levels misses a key point: Public debt owed to foreigners is different from debt owed to residents. Foreigners cannot vote for the higher taxes or lower expenditure needed to service the debt. Moreover, in the case of domestic debt, a higher interest rate or risk premium merely leads to more redistribution within the country (from taxpayers to bondholders). By contrast, in the case of debt owed to foreigners, higher interest rates lead to a welfare loss for the country as a whole, because the government must transfer resources abroad, which usually requires a combination of exchange-rate depreciation and a reduction in domestic expenditure.

This distinction between foreign and domestic debt is particularly important in the context of the euro crisis, because eurozone countries cannot devalue to increase exports if this is required to service foreign debt. And the evidence confirms that the euro crisis is not really about sovereign debt, but about foreign debt.

Indeed, only those countries that were running large current-account deficits before the crisis were affected by it. The case of Belgium is particularly instructive, because the risk premium on Belgian sovereign debt has remained modest throughout most of the euro crisis, although the country’s debt/GDP ratio is above the eurozone average, at around 100%, and it went without a government for more than a year.

An even starker example of the crucial difference between foreign and domestic debt is provided by Japan, which has by far the highest debt/GDP ratio among OECD countries. So far, the country has not experienced a debt crisis, and interest rates remain exceptionally low, at around 1%. The reason is obvious: Japan has run sizeable current-account surpluses for decades, giving it more than sufficient domestic savings to absorb all of its public debt at home.

What does this imply for Europe’s austerity debate? If foreign debt matters more than public debt, the key variable requiring adjustment is the external deficit, not the fiscal deficit. A country that has a balanced current account does not need any additional foreign capital. That is why risk premiums are continuing to fall in the eurozone, despite high political uncertainty in Italy and continuing large fiscal deficits elsewhere. The peripheral countries’ external deficits are falling rapidly, thus diminishing the need for foreign financing.

The debate about austerity and the high cost of public debt is thus misleading on two accounts. First, it has often been pointed out that austerity can be self-defeating, because a reduction in the fiscal deficit can lead in the short run to an increase in the debt/GDP ratio if both the debt level and the multiplier are large. But austerity can never be self-defeating for the external adjustment. On the contrary, the larger the fall in domestic demand in response to a cut in government expenditure, the more imports will fall and the stronger the improvement in the current account – and thus ultimately the reduction in the risk premium – will be.

Italy’s experience is enlightening: the large tax increases implemented by former Prime Minister Mario Monti’s technocratic government in 2012 had a higher-than-expected impact on demand. The economy is contracting so much that the debt/GDP ratio is actually increasing, and the actual deficit is improving only marginally, because government revenues are falling along with GDP. But a side effect of the fall in GDP is a strong decline in imports – and thus a strong improvement in the current account, which is why the risk premium continues to fall, despite the political turmoil unleashed by the country’s inconclusive recent election.

Second, if foreign debt is the real problem, the escalating debate about the Reinhart/Rogoff results is irrelevant for the euro crisis. Countries that have their own currency, like the United Kingdom – and especially the United States, which can borrow from foreigners in dollars – do not face a direct financing constraint.

For these countries, it matters whether history suggests that there is a strong threshold effect once public debt exceeds 90% of GDP. But the eurozone’s peripheral countries simply did not have a choice: they had to reduce their deficits, because the foreign capital on which their economies were so dependent was no longer available.

But the reverse is also true: as soon as the current account swings to surplus, the pressure from financial markets abates. This is likely to happen soon. At this point, peripheral countries will regain their fiscal sovereignty – and will be able to ignore Reinhart and Rogoff’s warning at their own risk.

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    1. CommentedPaul Peters

      Odd, i thought this whole "austerity" discussion was to raise the impression that governments were financially accountable.. a sort of Sarbanes Oxley, at least in whatever is being said to the press, so that thousands of high-frequency trading systems would not jump onto these countries and try speculate against them because these systems are too stupid to deal with any sort of nuance and ambiguity and have been projecting the implicit assumptions that underly algorithmic trading into an enforcing enactment which reduces the public image of government leaders to a sort of cartoonified version of themselves. Trapped.

    2. CommentedRalph Musgrave

      The distinction between foreign and domestically held public debt was pointed out by R.A.Musgrave in the American Economic Review in 1939. Smart lot we Musgraves :-)

    3. CommentedFrank Aten

      Seems to me risk premiums fell for the periphery do to bank buying and ECB taking debt in as collateral for repo not because investors feel things are "ok". I don't care if the threshold is 90% more or less depending on particular macros the debt levels (used for mal-investment) are absolutely a growth stunter. Soon governments won't be able to afford to provide the"essential" services for which is there sole purpose of existence.

    4. CommentedGerald Silverberg

      The distinction between foreign and domestic debt is indeed crucial for financial sustainability.

      However, I'm surprised Gros is still repeating the Reinhart-Rogoff canard about a 90% debt ratio threshold. Even without their egregious mistakes, this was always statistical nonsense (see my blog

        CommentedJose araujo

        On a monetary union, with free capital flow like the EU, there is no distinction between domestic and European debt.

        Why would a Portuguese or Greek national require less guarantees then a German or Dutch national for having his money in Portugal or Greece? If they do, the rational reaction is to put his money in Germany or Holland, isn't it?

    5. Commentedtony smith

      "But austerity can never be self-defeating for the external adjustment. On the contrary, the larger the fall in domestic demand in response to a cut in government expenditure, the more imports will fall and the stronger the improvement in the current account – and thus ultimately the reduction in the risk premium – will be."

      This is a deeply flawed analysis that doesnt belong on the otherwise excellent project-syndicate website.

      Austerity can be self-defeating if it inflicts medium/long-run damage to the countrys economy and productive capacity. Austerity has meant for the likes of Spain and Greece, a talent drain out of the country, the dismantling of public institutions and the breakdown of communities that will have long lasting effects. Although, as you correctly say a collapse in imports will mean a short-term improvement in the external debt position it comes at a great cost that will have long-term repercussions.

      Furthermore, the predominant factor that led to lower yields on periphery countries debt was the LTRO operation not the current accounts of those countries.

    6. CommentedPhilippe Abeille

      I like these distinctions between internal debt and external debt but in fact we don't know exactly what is internal or external because SPV and Tax Havens are often used and what we call "financial market" is a pure mix of "money coming from we don't know where". Money can be printed also, out of thin air. In addition, these explanations are purely "technocratic": there is no reference to "global inequality", to "wealth distribution". So as the markets, these concepts are purely inefficient for the people.

    7. CommentedErnest Dautovic

      why then the U.S. did not have a sovereign debt crisis after the subprime malaise caused by the twin deficits? And what would be the mechanism linking the private sector current account deficits with the sovereign spreads? In the end it wasn't the sovereign that were trading. However, we see that after the last summer the ECB decided for the OMT the spreads fell down, and Portugal this week got access to the markets again.

      Moreover in a region where countries are trading among themselves, the current account story would imply that none of them has ever to be in the minus territory otherwise she risks the market punishment. But if they trade among themselves someone has to have positive current account and someone negative current account, unless they all even out at zero. Funny guy Gross, luckily enough he is not teaching anywhere. Unfortunately though he has influence on EU politicians mindset.

        CommentedCarol Maczinsky

        The United States is a nation state. Eurozone is a coalition of nation states with a pooled currency and when nations do not meet their agreed targets they automatically harm the other members states and live off their pockets. In the past we had no enforcement of discipline. Now the situation of the crisis forces greater discipline as the partz of unaccounted spending is over and thus the US armchair professors come and denounce European "austerity", a misleading word for compliance with what a nation agreed upon. Of course austerity is no fun but either you eat your piece of cake or you take from others (with whom you bought the cake). The trolls from the US who propose that the others also take your piece of cake are safe to ignore.

    8. CommentedDan Adams

      R&R data wasn't falsified. It was selective which economists knew pretty quickly and is standard procedure in all science and social science.

      However this paper isn't really about R&R. The argument about debt here specifically foreign debt is valid.

        CommentedP. Foofootos

        Yes, the argument about foreign debt is valid.

        OTOH the reduction in current account deficits wasn't achieved through higher competitiveness, or through higher consumption from core European countries: it was achieved by "starving" (without quotes in some cases) in periphery countries. I wouldn't call that progress exactly. Not to mention that this is something everyone new, there are many articles, sometimes from more than 3-4 years ago, discussing the difference between foreign and internal debt, especially from economists that have studied Japan in depth.

        P.S. selecting and binning data specifically to suit a pre-defined hypothesis and threshold, IS a form of falsification. A paper in the medical field for example that deliberately fixed the data to say that a given condition was worsened by such and such factors, while in reality the condition was improved, just at a slower pace because of this factors, would be retracted.

    9. Commentedmichael L

      It seems that Daniel Gros has completely missed the true reason behind the falling spreads on PIIGS govvies:
      The promise from Draghi to do whatever it takes to save the Euro, the OMT programme, and the general perception that the ECB perhaps is a credible Lender of Last Resort after all.

      The massive suffering imposed by the policymakers on the population of the PIIGS with mass-unemployment, falling GDP, negative debt-dynamics, bankruptcies, etc. is really a crime against humanity. Of course the current account will turn positive when aggregate demand is deficient enough. This it not something to be happy about, but to deplore.

      But I bet that Mr Gros himself has not been forced to endure much suffering during this dramatic period of destruction. Other people will do the suffering...

    10. CommentedJose araujo

      Just the mention to R&R proves again that Gros is an ignorant, and that its because of people like him, that worked in IMF and advisory for the European Commission that Europe is like it is.

      Yes Gros and others like him make any debate irrelevant, there is no limit to stupidity and Gros proves it.

    11. CommentedP. Foofootos

      Reinhart - Rogoff? Really? Is the economics profession so anti-scientific that it stoops so low as to cite irreproducible research with falsified data?

      I'm sorry but that is why economics will always be seen as a faith-based (not religious, but political, small difference) black art rather than science... this is just a disgrace in the eyes of any scientist or engineer.

        CommentedRalph Musgrave

        Re Rogoff etc, members of every profession invariably scratch each other’s backs. Everyone knows Rogoff is incompetent. But his fellow academic economists will be the last to admit it.

        CommentedP. Foofootos

        Wrong, there are literally HUNDREDS of papers coming to the same conclusions in that case! I'd say that the result is pretty much reproducible and consistent. This paper didn't just have statistical errors: it selectively used data, and processed them in such a way as to support a conclusion, that not just wasn't supported by the full dataset, but was completely reversed!!

        CommentedMark Pitts

        Similarly, we must conclude that the whole idea of climate change has been debinked due to their statistical errors. Right?

        CommentedJose araujo

        Daniel Gros is a disgrace to the Economist Class, for sure in Engineering and natural sciences are also full of incopetent people in high places.

    12. CommentedFlint O'Neil

      Thank-god for this. I thought I was the only one who shared this opinion on the Austerity debate.