Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 29 March 2012

Is Eurozone Austerity Self Defeating, and is it all Germany's fault?

                Suppose DeLong and Summers (full paper here) are right, and at the zero lower bound temporary fiscal stimulus leads to an eventual reduction in the debt to GDP ratio because of hysteresis. Does that mean that all this austerity in the Eurozone is counterproductive? This is the question raised by John McHale. Here is an attempt at an answer, followed by some more general remarks on European austerity.

In the stylised picture above, the black line represents the debt to GDP ratio under ‘austerity’. The budget deficit is being reduced rapidly, first to stabilise the debt to GDP ratio, and then to bring it down to safer (more optimal?) levels. ‘Stimulus’ involves in the short term cutting government spending less (at least). Unless multipliers are implausibly large this will raise both deficits and the debt to GDP ratio in the short run (the red line). What DeLong and Summers argue is that the negative effects of austerity on output in the medium term will mean that the two paths for debt to GDP will at some point cross. In other words stimulus will at some point lead to a better outcome for the debt to GDP ratio.
                For any government not having to pay a large risk premium on their debt, and not likely to encounter such a premium, this is an important argument. If true, it does indeed suggest that the rapid austerity being undertaken by countries such as the UK will eventually make their fiscal position worse. In addition, arguments that we have to follow the austerity path because the stimulus path is not credible are beside the point, as I argue here (and see also Summers here). Nor does the argument that we cannot change course now make much sense. In the UK and US fiscal policy does not have to be credible, it just needs to be sensible.
In the case of Ireland and other Eurozone countries the immediate motivation for austerity is a high risk premium on government debt. What potential investors in Irish government debt are worried about is not where debt is likely to end up, but the likelihood of default before we get there. Here the credibility argument does apply.
                One reason why government might default is a political inability to cut spending or raise taxes enough to get the primary budget balance into surplus. Governments can demonstrate that they do have that ability by cutting the deficit rapidly now. Promises to cut it in the future carry much less weight, and so as a result have less impact on the chance of default. Even when the primary balance is in surplus, a government may decide it is in the country’s best interest to default, because any damage to its reputation will be offset by the advantages of not having to cut spending or raise taxes still further to pay the interest on its debt. Once again, a government can demonstrate that it is not minded to do this by reducing its debt as quickly as possible.
                In either case, default is less likely if debt follows the black line (austerity) rather than the red line (stimulus). The markets are, quite rightly, not very interested in what happens into the medium term, because by that time default risk under either policy has all but disappeared. So if the overwhelming priority is to reduce the risk premium on government debt, austerity makes sense. In addition, as I have said often before, a long period of economic stagnation is required in many Eurozone countries to reverse the competitive disadvantage they accumulated relative to Germany in the early years of this century.
                Which brings us to Germany. In the past I and others have written as if this Hobson’s choice faced by periphery Eurozone countries could be partially relieved if only Germany would expand more rapidly. However, as I outlined here, this was not a very realistic wish. Not because Germany is addicted to current account surpluses –Kantoos rightly argues that this idea is not exactly part of the German macroeconomic objective function. The reason we will not see rapid expansion in Germany is because the economy is doing all right as it is. While inflation of 5% in Germany would certainly be very useful for Spain et al, it would not be in the national German interest. The only possible exception might be if the Eurozone as a whole looked like coming apart, in which case it might be in Germany’s interests to incur these costs.
                Kantoos’s final question in his post is: ‘So what else should Germany do?’ Germany should be reasonably relaxed about getting its own debt to GDP ratio down. What I have called ‘competitive austerity’ in Europe is not helpful. But being more relaxed on debt is not going to make a big difference to the rest of the Eurozone. So the realistic answer to that question is probably ‘not much’.
                Seeing the Eurozone as a single bloc, it makes sense to note that fiscal correction in this bloc is far more rapid than in the US or even the UK, and for the area as a whole that will be very damaging. If there was a Eurozone government, it should be undertaking a substantial fiscal stimulus in Germany right now. But to blame Germany for not doing this of their own accord is rather pointless, as Kantoos says in a more recent post.
                So the only real hope is monetary policy. I’m glad to see that Scott Sumner has decided to bury the hatchet, so let me say some more things that I think he will like to hear. While the arguments for price level or nominal GDP targets are pretty universal, I think they apply particularly to the Eurozone. The discussion above suggests that the barriers to fiscal stimulus in the Eurozone are not political but intrinsic to the union in its current conjuncture, so there appears to be no alternative to monetary stimulus. A change from inflation targeting may also be politically easier for the ECB, because it could be justified as a move back towards the ‘twin pillars’ approach and the Bundesbank’s money supply targeting. Perhaps with a new head the institution can make up for recent mistakes. A major obstacle may be that such a change would not be in Germany’s short term interests (for all the reasons noted above), in which case we may find out how independent the ECB really is from Germany.


  1. Prof Wren-Lewis, You say “So if the overwhelming priority is to reduce the risk premium on government debt, austerity makes sense.” You’re not actually agreeing with the popular idea that austerity is required to pay off the debt are you?

    The idea that debt reduction requires austerity applies to micro economic entities. It does not apply to a monetarily sovereign country to any great extent. Such a country can simply print money and buy back debt. And to the extent that that is inflationary, it can counter that with extra tax: net austerity effect is zero.

    At least that is true of closed economies. Things a slightly more complicated for open economies, but not vastly more complicated.

  2. This largely misses the point. The implied point in the graph is that in the high default risks zone the country practicing austerity is less likely to default because it has a lower debt to GDP ratio but that is not correct. A country can always pay back its debt, however it can choose not to do so. It will not do so if economic conditions are dire. So default is more likely in the austerity case (black line) than in the expansionary case. Which is more likely to default or run into unmarketable debt? A country with debt to GDP of 100 running a deficit of 8 per cent with full employment and strong growth or a country with 80 debt/GDP with a deficit of 5 per cent with 25 per cent unemployment and violent rioters rampaging through the streets. If you think the later I’m got some Spanish bonds for sell.

  3. Simon
    Isn't his defense of short term austerity only relevant in the context of European folly of imposing a kind of gold standard on its member countries and failing to let the ECB act as lender of last resort to sovereigns? Shouldn't we be concentrating on these mistakes?

  4. Thanks for the neat graphic and clear explanation.

    The problem for the eurozone countries is that they have adopted a self imposed constraint, and cannot freely print their own currency. They then failed to make the necessary structural adjustments that would allow them to live with that constraint, and are now having to do so in the wake of a global financial firestorm. Hard to be an optimist. Problem is, dropping out of the euro is seen as a non-option too, which leaves them between sylla and charibdes.

    In terms of broader economic responses, the obvious first step is loose ECB policy, and under Draghi they have moved it seems from the Trichet lunacy of tightening in the middle of this mess. But I can't help thinking this just isn't enough. Europe needs some sort of coordinated fiscal expansion, but that simply isn't going to happen. The mechanisms to do it are not in place, and nor is the political will.

  5. The discussions over the low cost of fiscal policy are very worthwhile, but where are the stimulus side of the debate going to spend the funds? I think that economists tend to use stimulus as just a factor to plug into their equations. I think that economists and should spend more time talking to engineers and scientists, and I think in our current position, the engineering input is more important and more 'shovel ready'.

    For instance, take the Hoover Dam as a stimulus program, as discussed in 'Dam the Economists' at "The Hoover Dam and its associated power and irrigation projects cost $165 million in 1933 dollars and created 16,000 jobs at the height of the Depression. Interest charges during construction were $17 million. Total cost was $1.25 for every man, woman and child in America, which Dr. Cochrane would dismiss as interfering with free enterprise and stealing jobs and capital from the private sector. In reality, the dam cost citizens nothing: the $1.25 actually represents a collective (oops…nasty socialist word) investment by the entire citizenry. .... continues to generate over $400 million a year from selling electricity."

    Why doesn't the EU figure out some collective project, like an EU-owned interconnected high voltage DC grid and switch to renewables, much as Roosevelt's REA was such a great stimulus program (with a default rate on small REA companies of less than 1%.) One can only imagine the loud howls from the extractable/fossil fuel energy sector if this were to happen, but it's all moot anyway if we don't do something soon.

    Engineers and physicists gain understanding by looking at corner problems...and according to UC San Diego physicist Tom Murphy, the residual heat from the current rate of economic expansion will heat the earth to boiling in about 400 years, not global warming but global cooking, as he discusses in his piece, Exponential Economist Meets Finite Physicist' at

    The current system of economies in thrall to extractive technologies and bloated financial sectors will continue to deliver ever more crises to stimulate abstract economic debate. Economists should pay equal attention to the larger issues that are facing us if they want to be part of the solution. I like Brad DeLong's very personal piece here;

  6. Germany's perceived self interest. The German's haven't explained why they don't want 5% inflation. In noted contrast to, well just about everything else, economists accept that a high perceived cost of inflation is a statement of preferences, so polity sovereignty is respected. The same is not at all true for, say labour (note the courteous spelling) market regulations or entitlement programs.

    Efforts to calculatethe cost of inflation using standard modelssuggest that the cost of moving from 2% to 5% is tiny. Efforts to understand why ordinary people hate inflation cause them to makeit very clear thatthey consider price inflation for fixrped nominal income and assume the choice isbetween high and low real wages with the sameemployment and output.

    Clearly, no practical aim can be achieved by attempting to convince German's that 5% inflation and temporarily slighlty lower unemployment is preferable to 2% inflation, but I have no doubt that this is the case.

  7. Do we know how smart markets are? If they're so smart, then the short run is irrelevant, since they can compute the present discounted value as well as you do, using the correct risk-adjusted discount rate, and will not therefore "request" unreasonable risk premia, and your argument does not apply. If they're dumb, then the point is about credibility, and do we know what markets perceive as a signal of credibility? Your point is that markets would perceive austerity as a positive signal. However, there is by now ample evidence that that is not true. And if I'm not mistaken Krugman repeatedly hammers the point, with which I agree, that austerity does not send reassuring signals to markets. So unless I've missed something I think I have just debunked your argument here.


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