Sunday, November 23, 2014

The Wrong Austerity Cure

BERKELEY – Fiscal profligacy did not cause the sovereign-debt crisis engulfing Europe, and fiscal austerity will not solve it. On the contrary, such austerity has aggravated the crisis and now threatens to bring down the euro and throw the global economy into another tailspin.

In 2007, Spain and Ireland were models of fiscal rectitude, with far lower debt-to-GDP ratios than Germany had. Investors were not worried about default risk on Spanish or Irish sovereign debt, or about Italy’s chronically large sovereign debt. Indeed, Italy boasted the lowest deficit-to-GDP ratio in the eurozone, and the Italian government had no problem refinancing at attractive interest rates. Even Greece, despite its rapidly eroding competitiveness and increasingly unsustainable fiscal path, could attract the capital that it needed.

Deluded by the convergence of bond yields that followed the euro’s launch, investors fed a decade-long private-sector credit boom in Europe’s less-developed periphery countries, and failed to recognize real-estate bubbles in Spain and Ireland, and Greece’s slide into insolvency. When growth slowed sharply and credit flows collapsed in the wake of the Great Recession, budget revenues plummeted, governments were forced to socialize private-sector liabilities, and fiscal deficits and debt soared.

With the exception of Greece, the deterioration in public finances was a symptom of the crisis, not its cause. Moreover, the deterioration was predictable: history shows that the real stock of government debt explodes in the wake of recessions caused by financial crises.

Overlooking the evidence, European leaders, spearheaded by Germany, misdiagnosed the problem as one of fiscal profligacy for which painful austerity is the only cure. On this view, significant and rapid reductions in government deficits and debt are a precondition to restoring government credibility and investor confidence, stemming contagion, bringing down interest rates, and reviving economic growth.

There is also a moral-hazard aspect to the austerity argument: easing repayment terms for spendthrift governments will only encourage reckless behavior in the future – forgiving past sins perpetuates sinning. Moreover, virtuous creditors should not bail out irresponsible borrowers, be they private or public. From this perspective, austerity is the necessary and just penance for reprobates like Greece, Spain, and Italy.

But austerity is not working; indeed, it is counterproductive. In the short to medium run, fiscal consolidation – whether in the form of cutting government spending or increasing revenues – results in lower output and employment, which means lower tax collection, higher deficits, and escalating debt relative to GDP. Savvy investors, like frustrated voters, recognize that low growth and high unemployment actually enlarge deficits and add to debt in the short run. That is why, after more than two years, interest rates are rising, not falling, in countries crushed by onerous austerity measures.

In fact, there is no simple relationship between the size of a government’s deficit or debt and the interest rate that it must pay. British government bonds now offer significantly lower interest rates than those of France, Italy, or Spain, even though the United Kingdom’s fiscal position is considerably worse.

Greece is caught in a classic debt trap, as the interest rate on its public debt has soared beyond its growth rate by a considerable margin; Spain is teetering on the brink. Austerity in Europe has confirmed the International Monetary Fund’s warning that overdoing fiscal consolidation weakens economic activity, undermines market confidence, and diminishes popular support for adjustment.

In the long run, many eurozone countries, including Germany, require fiscal consolidation in order to stabilize and reduce their debt-to-GDP ratios. But the process should be gradual and back-loaded – with much of the consolidation coming after Europe’s economies have returned to a sustainable growth path.

Structural reforms are also necessary in most European economies to bolster competitiveness and boost potential growth. But such reforms take time: German Chancellor Angela Merkel appears to have forgotten that it took more than a decade and roughly €2 trillion ($2.5 trillion) in subsidies for structural reforms to make the former East Germany competitive with the rest of the country.

Italian Prime Minister Mario Monti and French President François Hollande are right: Europe needs bold, coordinated policies to promote growth, along with market-based structural reforms to foster competition and an easing of fiscal targets until output and employment recover.

But how can significant new growth initiatives be financed? The reality is that the rest of Europe cannot succeed in restoring growth without Germany, and Germany remains wedded to the austerity cure.

With a modest fiscal deficit, record-low borrowing costs, and a huge current-account surplus, Germany has the financial firepower to unleash a significant stimulus. But Germany sees no need to stimulate its own economy, and is willing to consider only modest eurozone measures, such as additional capital for the European Investment Bank, a small pilot program for European Union “project bonds” for infrastructure investment, and more rapid deployment of unspent EU structural funds. Germany refuses even to allow spending on high-priority infrastructure projects to be exempted from the unrealistic deficit targets set by the EU’s new “fiscal compact.”

Despite pleas from the IMF and the OECD, Germany also remains implacably opposed to Eurobonds, which could ease the funding constraints of other eurozone members and bolster the resources of the European Stability Mechanism, which currently does not provide a credible firewall against a run on Spanish or Italian sovereign debt – or on the European banks that hold it. Indeed, the worsening banking crisis, with deposits fleeing from the eurozone periphery, is further strangling Europe’s growth prospects.

It is probably too late to save Greece. But a shift toward policies to promote growth, supported by the easing of deficit targets and the issuance of Eurobonds, is essential to bring Europe back from the brink of sustained recession, to stabilize Europe’s financial markets, and to prevent another significant disruption to global capital markets.

Read more from our "Are Eurobonds a Silver Bullet?" Focal Point.

  • Contact us to secure rights


  • Hide Comments Hide Comments Read Comments (8)

    Please login or register to post a comment

    1. CommentedRoss Clem

      The ability of government to repay its debt determines the interest rate on its debt. Government must increase its income by increasing revenue based upon the growth of the private sector; or it must reduce the cost of government.

    2. Commentedjracforr jracforr

      The first sentence of this article stated that fiscal recklessness was not the cause of the debt crisis and it gave examples of the well managed !!?? Spanish and Irish governments. By the third paragraph it gave blatant examples of fiscal recklessness taking place in these countries, which created the the real-estate bubble.
      The governments of these countries derived tax revenues from these speculative investments done by the private sector and were conveniently blind to the
      looming danger they posed .
      The " governments were forced to socialize private-sector liabilities " when the speculative boom collapsed.
      " From this perspective austerity is the necessary and just penance for reprobates like Greece ,Spain and Italy'
      While this approach maybe morally correct it is economically suicidal as the article makes clear, so some burden sharing is inevitable.

    3. CommentedJephtah Lorch

      I beg to differ with Ms Tyson on the basics of the European (and not only) fiscal problem.

      The term 'growth' is used far to easily. Growth depends on household consumption, what is manufactures, shipped, serviced, etc. Yet, household spending is shrinking and has been doing so for many years. This is especially true in Europe where the population is getting older, birth rates are under 1.8 pointing at an inevitable future shrink, many immigrants are net expenses and, very important, a massive shift of jobs to SE Asia took place.

      I fail to understand how investments in infrastructure will provide more future jobs: people lack financial resources to use such infrastructure, it creates only short term government spending (serving very specific sectors), boosts profits of infrastructure contractors and return some of the government's funds as taxes. This will not create long term increase of all households income and respective cosumerism that fuels growth.

      Issuing EURO Bonds is another laundered way to increase public debt. Public debt is huge as is, especially when compared to long term earning potential in shrinking populations and economies. These will affect GDP's mostly due to internal cash transfer 'inside the family', rather than from real manufacturing, production and exports.

      Economists, who don't want to be carriers of bad news, need to face the fact that this balloon has inflated to its limits much like Japans 1990s' real-estate crash which froze the economy for over a decade. A new order will come to life and should be put in place. It should avoid repeating the errors that brought us to where we are. It should consider the realistic posibilty that economies will shrink, standard of living will be reduced and that globalization shifted riches from west to east.

    4. CommentedTh Hsu

      There seems to be an interesting gap between the underlying issues and proposed cures.

      Spain's growth was built on an unsustainable increase in real estate "value". Italy and France's economy are overloaded with regulations and a costly public service. Greece simply cheated it's neighbours throughout years. And Germany was happy too to increase debt beyond agreed levels when needed. So where is the solidarity aspect which has been so oft brought up by the EU leaders? It seems that in this UNION, everyone has been (and will be) maximizing their local interests.

      If this is the underlying problem, it is hard to believe that neither austerity nor the growth "concept" will be a sustainable solution.

      This crisis is an example to the thesis that in the real world, fiscal and monetary union are two parts of the same coin. Pull them apart and ...

    5. CommentedHelmut Kirchner

      Just some info from ITALY

      Nowadays it is usual to say that austerity is the wrong cure that worse the disease. For what I see in Italy I do not see any "austerity". This word, long time ago, means spending more wisely and do more with less.

      What I see in Italy is the same level and the same low quality of public spending but a new and extreme, I repeat extreme fiscal pressure.

      So there is no way to recover! In fact Italy is already in a depression even if no one dime of public spending has been reduced.

      Sorry, but the Germans are right.

    6. CommentedJames Edwards

      In response to Mark Pitts

      While it is true that most of these countries are in need of reform on a range of issues however when you get into the issue of politics, the tendency to skirt responsibility is magnified by the desire to win and pin blame on the other side.

      You ignored the cause of the problem in the first place and that problem stems from issuance of easy credit to finance whatever the wants are which Ms. Tyson addressed here and that has been going on since the late 1980s until the bubble popped in 2007. Many of the banks and Wall Street were eager to do it because it offers them opportunities to make money and securitization provided the avenue to generate all kinds of variable products never mind the risk because it is someone else's problem to solve hence why many governments bailout their financial institutions because letting it fail will cause a bigger problem. What I don't see is the needed reforms the banks should be imposing on itself to correct the defect they created in the first place. Just like Ms Tyson stated: the deterioration was predictable.

      I can understand Germany's view that needed reforms are needed however the EU consist of rich and poor nations, just like what we have in the US but on a different level however the each of the countries are wedded to the Euro and they can not do anything beyond making painful adjustment which is why Merkel's party lost two state elections and Mr. Hollande's victory caused her of modify her stance just to keep the Euro intact. Germany's solution sounds like a one size fits when it is several things going at the same time.

      You state it is a recession when it is really a Depression caused by the financial crisis and even model countries needs a bailout unless they enacted reform to prevent from happening in years prior to 2007.

    7. CommentedMark Pitts

      In rebuttal to Ms. Tyson’s argument, one only needs to reiterate many of the points already made by the Germans. For example:

      1) The issuance of Eurobonds relieves other nations of the need to make painful and unpopular reforms. Eurobonds mean reforms will not be made, interest rates will once again be equalized in the EU, and excessive borrowing in the peripheral countries will resume.

      2) Debtor countries already receive substantial aid or have access to it, but still resist implementing reforms that will lead to growth and competitiveness.

      3) Mr. Hollande, the newest voice for growth and reforms, has pledged to lower the French retirement age back to 60. That will make French public finances worse and add nothing to GDP or competiveness. These are the kind of “reforms” the Germans are worried about.

      4) Ms. Tyson states that Spain and Ireland were models of fiscal rectitude before the recession. She then points out, “The reality is that the rest of Europe cannot succeed in restoring growth without Germany.” There is an obvious contradiction here. Model countries do not require bailouts from other countries when recessions hit.

      To understand the German point of view, Americans need only convert the numbers involved to an equivalent in the US economy. For example, it has been estimated that the cost of bailing Spain’s banks and governmental units will cost around $350B. Would Americans be willing to bail out Mexico at a cost of $1.25 trillion, knowing that other countries in the region would soon line up for their bailouts as well?

      Finally, it is unfair to discredit the German position by equating it to moral or religious vengeance. As a result of their economic history, Germans may have different beliefs about the likely outcomes of certain policies than others do. However, there are many mainstream economists who question the simplistic Keynesian solution as well.

    8. CommentedZsolt Hermann

      The suggestions from the article sound logical.
      One question though: where would further growth come from?
      When will we become brave enough to face the facts that our present constant quantitative growth economic model, that is built on overproducing and over consuming excessive, unnecessary products, buying them beyond means requiring more and more credit, has exhausted itself due to multiple converging factors and this is why we are in a crisis, or more precisely system failure?
      Until we are ready to open up the root cause of the disease we cannot even hope for a cure.