Why Austerity?

On Friday, August 5, 2011, what used to be the fiscally unthinkable

happened. The United States of America lost its triple A (AAA) credit
rating when it was downgraded by the ratings agency Standard &
Poor’s (S&P’s). This is a bit of a problem since the US dollar is the
world’s reserve currency, which means (basically) that the dollar is
treated as the emergency store of value for the rest of the world;
practically all tradable commodities, for example, are valued in
relation to the dollar, and the dollar serves as the anchor of the
world’s monetary system. The following Monday, August 8, 2011,
the Dow Jones Industrial Average (DJIA) lost 635 points, its sixth
worst loss ever. At the same time, a continent away, the turmoil in the
European bond market that began in Greece in 2009 now threatened
to engulf Italy and Spain, undermining the European single currency
while raising doubts about the solvency of the entire European
banking system. Meanwhile, London, one of the world’s great
financial centers, was hit by riots that spread all over the city, and
then the country.

The London riots quickly blew over, but then the Occupy movement
began, first in Zuccotti Park in Manhattan, and then throughout the
United States and out into the wider world. Its motivations were
diffuse, but one stood out: concern over the income and wealth
inequalities generated over the past twenty years that access to easy
credit had masked.1 Winter, and police actions, emptied the Occupy
encampments, but the problems that spawned those camps remain
with us. Today, the European financial-cum-debt crisis rolls on from
summit meeting to summit meeting, where German ideals of fiscal
prudence clash with Spanish unemployment at 25 percent and a Greek
state is slashing itself to insolvency and mass poverty while being
given ever-more loans to do so. In the United States, those problems
take the form of sclerotic private-sector growth, persistent
unemployment, a hollowing out of middle-class opportunities, and a
gridlocked state. If we view each of these elements in isolation, it all
looks rather chaotic “From Those Wonderful Folks That Brought You
Pearl Harboreminfluence. But look closer and you can see that these
events are all intimately related. What they have in common is their
supposed cure: austerity, the policy of cutting the state’s budget to
promote growth.

Austerity is a form of voluntary deflation in which the economy

adjusts through the reduction of wages, prices, and public spending to
restore competitiveness, which is (supposedly) best achieved by
cutting the state’s budget, debts, and deficits. Doing so, its advocates
believe, will inspire “business confidence” since the government will
neither be “crowding-out” the market for investment by sucking up all
the available capital through the issuance of debt, nor adding to the
nation’s already “too big” debt.

As pro-austerity advocate John Cochrane of the University of Chicago

put it, “Every dollar of increased government spending must
correspond to one less dollar of private spending. Jobs created by
stimulus spending are offset by jobs lost from the decline in private
spending. We can build roads instead of factories, but fiscal stimulus
can’t help us to build more of both.”2 There is just one slight problem
with this rendition of events: it is completely and utterly wrong, and
the policy of austerity is more often than not exactly the wrong thing
to do precisely because it produces the very outcomes you are trying
to avoid.

Take the reason S&P’s gave for downgrading the US credit rating.
They claimed that, “the prolonged controversy over raising the
statutory debt ceiling and the related fiscal policy debate “… will
remain a contentious and fitful process.”3 Yet the DJIA didn’t fall off
a cliff because of the downgrade. To see a downgrade on Friday
followed by a DJIA collapse on a Monday is to confuse causation and
correlation. Had the markets actually been concerned about the
solvency of the US government, that concern would have been
reflected in bond yields (the interest the United States has to pay to
get someone to hold its debt) before and after the downgrade. Bond
yields should have gone up after the downgrade as investors lost faith
in US debt, and money should have flowed into the stock market as a
refuge. Instead, yields and equities fell together because what sent the
markets down was a broader concern over a slowing US economy: a
lack of growth.

This is doubly odd since the cause of the anticipated slowdown, the
debt-ceiling agreement of August 1, 2011, between Republicans and
Democrats in the US Senate that sought $2.1 trillion in budget cuts
over a decade (austerity), was supposed to calm the markets by giving
them the budget cuts that they craved. Yet this renewed commitment
to austerity instead signaled lower growth due to less public spending
going forward in an already weak economy, and stock markets tanked
on the news. As Oliver Blanchard, the International Monetary Fund’s
(IMF’s) director of research, put it with a degree of understatement,
“Financial investors are schizophrenic about fiscal consolidation and
growth.”4 Today the US debt drama is about to repeat itself in the
form of a so-called fiscal cliff that the United States will fall off when
automatic spending cuts kick in in January 2013 if Congress cannot
decide on what to cut.

The schizophrenia Blanchard identified a year previously continues

this second iteration, with both sides simultaneously stressing the
need for cuts while trying to avoid them. a long-run evolutionary
structure that government intervention Austerity policies were
likewise supposed to provide stability to the Eurozone countries, not
undermine them. Portugal, Ireland, Italy, Greece, and Spain (the
PIIGS of Europe) have all implemented tough austerity packages
since the financial crisis hit them in 2008. Greece’s bloated public-
sector debt, Spain’s overleveraged private sector, Portugal’s and
Italy’s illiquidity, and Ireland’s insolvent banks ended up being bailed
out by their respective states, blowing holes in their debts and deficits.
The answer to their problems, as with the US debt-ceiling agreement,
was supposed to be austerity. Cut the budget, reduce the debt, and
growth will reappear as “confidence” returns.

So PIIGS cut their budgets and as their economies shrank, their debt
loads got bigger not smaller, and unsurprisingly, their interest
payments shot up. Portuguese net debt to GDP increased from 62
percent in 2006 to 108 percent in 2012, while the interest that pays for
Portugal’s ten-year bonds went from 4.5 percent in May 2009 to 14.7
percent in January 2012. Ireland’s net debt-to-
GDP ratio of 24.8 percent in 2007 rose to 106.4 percent in 2012,
while its ten-year bonds went from 4 percent in 2007 to a peak of 14
percent in 2011. The poster child of the Eurozone crisis and austerity
policy, Greece saw its debt to GDP rise from 106 percent in 2007 to
170 percent in 2012 despite successive rounds of austerity cuts and
bondholders taking a 75 percent loss on their
holdings in 2011. Greece’s ten-year bond currently pays 13 percent,
down from a high of 18.5 percent in November 2012.5 Austerity
clearly is not working if “not working” means reducing the debt and
promoting growth.

Back in 2009, with the world reeling from the fallout of the financial
crisis, Greece’s government made a confession: Its finances were in
horrific shape.

After enjoying borrowing in the credit market on almost the same

favorable terms as Germany, the Greek government found itself
unable to pay back its debts.

The European Commission, the European Central Bank and the

International Monetary Fund — often referred to as the troika —
came to the rescue, but Greece had to adhere to strict austerity
measures: cutting public spending and raising taxes, to name two of
the tough terms.

The austerity measures were described as necessary medicine —

bitter at first but ultimately just what the patient needed, at least in
theory. In practice, though, fiscal contraction in Greece (and in other
financially stressed European countries, such as Spain, Portugal and
Italy), led to an even deeper recession with mass unemployment,
while debt levels increased and budget deficits widened, as shown in
the chart below.
So what’s wrong with fiscal austerity?

Economic austerity — the kind that has been prescribed by the troika
— is based on a flawed and dangerous ideology, the most tragic part
of which is that it doesn't work, according to Mark Blyth, a professor
of macroeconomics at Brown University and the author of “Austerity:
The History of a Dangerous Idea.”

Blyth joins renowned economists and Nobel Prize winners Joseph

Stiglitz and Paul Krugman in harshly criticizing austerity.

Austerity measures are primarily aimed at shrinking debt as a

proportion of a country’s economic output, a measure known as the
debt-to-GDP ratio. Austerity proponents see high debt as the largest
impediment to growth.

Raising taxes and cutting public spending too aggressively can

potentially lead to a recession under normal circumstances, but it can
result in far worse outcomes when implemented during a period of
economic contraction. Even if total debt is reduced, the debt-to-GDP
ratio can rise because gross domestic product shrinks in tandem.

Krugman, a noted academic economist and a columnist at the New

York Times, has crusaded against austerity for years. In an April 29
column titled “The austerity delusion,” the Keynesian presented a
chart from the IMF showing that more austere countries have lower
rates of growth.

In the case of Greece, austerity measures have devastated the

economy, according to some economists.

“I can think of no depression, ever, that has been so deliberate and

had such catastrophic consequences,” Joseph Stiglitz wrote in an op-
ed for the Huffington Post just days before Greece’s prime minister,
Alexis Tsipras, called a July 5 referendum on the bailout terms being
put to the country.

“I don’t believe Europe’s leaders were seeking to punish Greece.

They were just using bad models — evidenced by the enormous gap
between what they thought would happen and what did happen,”
Stiglitz wrote. “Europe and the International Monetary Fund predicted
a fairly quick turnaround. The reality was deepening recession.”

Inflate, devalue, deflate, default

Countries running huge deficits and unable to pay off their sovereign
debt have four ways to get out of their difficult economic situation:
inflate, devalue, deflate or default, Blyth has written.

Inflating and devaluing are options available only to countries with

independent central banks and their own currencies, like the U.S. and
U.K. Before the creation of the euro, southern European countries
regularly devalued their currencies against the Deutsche mark in times
of distress.

But since the adoption of the euro, countries such as Greece have
been put in a euro straitjacket, as they cannot devalue, economist
Desmond Lachman, a research fellow at American Enterprise
Institute, noted.

Default is one of the most painful options, but, as Argentina, Ecuador,

Peru and Russia discovered, a country can recover from it and even
expand its economy years down the road.

Debt forgiveness may be one of the better options, but negotiations

between the troika and Greece have been stickiest on this point.

The fact that austerity is still employed despite being viewed by

seminal thinkers as counterproductive may be the product of false
assumptions. A paper written in 1990 by economists Francesco
Giavazzi and Marco Pagano, titled “Can Severe Fiscal Contractions
Be Expansionary? Tales of Two Small European Countries,” may be
a source of this pro-austerity view.

The Giavazzi-Pagano paper, which has become the bible of the pro-
austerity movement, argued that fiscal contraction can lead to
economic growth (a view often called ordo-liberal, or “the German
view”). That paper centered on two countries: Denmark and Ireland.
John Maynard Keynes famously prescribed fiscal stimulus during
periods of economic depressions, which would be funded by
government borrowing and used on infrastructure and other projects
to create jobs and spur demand.

In contrast, the ordo-liberal view holds that persistent and severe cuts
to public spending will lower future taxes and therefore boost the
confidence of consumers and businesses.

To support their hypothesis, Giavazzi and Pagano used Denmark’s

and Ireland’s economic policies in the early 1980s as examples.

Indeed, both countries cut spending and raised taxes early that decade
only to experience expansion a few years later. But there are
important differences between the austerity practiced by Denmark and
Ireland and the austerity employed in the wake of the debt crisis. In
the 1980s, for example, austerity measures were accompanied by
complementary monetary policies. In other words, interest rates were
cut and currencies devalued before they were pegged to Germany’s
currency.

With interest rates currently near zero and eurozone countries using a
shared currency, neither of those scenarios was available to Spain or
Portugal — or to Greece, for that matter.

Another study that influenced the IMF’s preference for austerity

measures was published in 2009 by economists Alberto F. Alesina
and Silvia Ardagna. Those authors claimed that “smaller prospective
deficits may improve confidence among consumers and investors,
thereby raising consumption and lowering risk-premia in interest
rates.”

Their conclusion: “Fiscal stimuli based upon tax cuts are more likely
to increase growth than those based upon spending increases. As for
fiscal adjustments, those based upon spending cuts and no tax
increases are more likely to reduce deficits and debt-over-GDP ratios
than those based upon tax increases. In addition, adjustments on the
spending side rather than on the tax side are less likely to create
recessions. We confirm these results with simple regression analysis.”

This was followed by a paper published in 2010 by economists

Carmen M. Reinhart and Kenneth S. Rogoff titled “Growth in a Time
of Debt,” in which it was argued that debt levels exceeding 90% of
GDP in developed countries result in substantially lower growth. This
gave European policy makers (and, to some extent. U.S. politicians)
an impetus to focus on debt reduction rather than on unemployment.

The Reinhart and Rogoff paper was influential because it was based
on empirical data. However, in 2013, economists Thomas Herndon,
Michael Ash and Robert Pollin published a paper pointing out that
“coding errors and selective exclusions and unconventional weighting
of summary statistics lead to serious errors that inaccurately represent
the relationship between public debt and GDP growth among 20
advanced economies in the post-war period.”

Correlation, however, doesn’t necessarily mean causation. “[A]

negative correlation between debt and economic performance need
not mean that high debt causes low growth. It could just as easily be
the other way around, with poor economic performance leading to
high debt,” wrote Krugman.

Both the Alesina and Rogoff papers have been debunked by the
IMF’s own research arm. In 2012, the IMF admitted in a research
paper that severe fiscal austerity in the aftermath of the financial crisis
caused lower growth and higher unemployment than they had
anticipated because the multiplier effect of the cuts had been much
larger than forecast.

In a paper titled “Debt and Growth: Is There a Magic Threshold?”

published in February 2014, IMF researchers concluded that countries
with high but declining debt levels appeared to grow as fast as
countries with low debt levels. This makes sense: As countries are
able to grow faster, they are able to reduce debt.
While the IMF’s research department argued that excessive cuts in
spending and higher taxes don't have the desired effect of reducing
debt and deficits, while adversely impacting growth, the
organization’s executive leaders have been a lot more nuanced in
promoting austerity.

Mass unemployment, persistent misery and reduced standards of

living are often the fallout for economically troubled countries. Those
fiscal woes can result in emigration by some of the country’s most
skilled workers, further hobbling growth.

The anti-austerity sentiment has been gaining momentum among

academics and economists, recently.

Thomas Piketty, a French economist and author of the best-selling

“Capital in the Twenty-First Century,” told the Financial Times in a
recent interview that “it is ironic that austerity is imposed on debt-
laden Greece by two countries, Germany and France, that benefited
from debt cancellations after the second world war: a move that
allowed 30 years of growth on the continent.”

Debt forgiveness is one alternative that can help get countries like
Greece out of their fiscal messes, according to Blyth. But the most
recent agreement between the Hellenic Republic and its creditors
makes that option a nonstarter.

The testy talks between Greece and its creditors demonstrate that
austerity isn’t going away in Europe soon. So, it may not be long
before the next test of the merits of austerity emerges.