Ken Rogoff’s article in the FT today is a welcome return to sanity in the austerity debate. None of the nonsense about opponents of austerity believing growth would never return, or that austerity would have no impact on output. Instead Rogoff focuses on what was always the critical debate: was austerity necessary because financial markets might have stopped buying government debt. (See this post on the many justifications for austerity.)
As critical pieces go, you couldn’t have a friendlier one than this. First, Rogoff agrees that it was a mistake to cut back on public sector investment. He writes “Such projects, if done at a reasonable cost, pay for themselves. Governments should have done more ...”. He says that austerity critics “have some very solid points on their side”. When discussing key arguments, his comment after putting the austerity critics’ case is “perhaps” or “maybe”. In that sense this is a reasoned argument rather than a piece of advocacy.
The argument here is all about insurance. The financial markets are unpredictable beasts, and who knows what they might have done if – in particular – the Euro had collapsed. As Rogoff acknowledges, they might have run for cover into UK government debt, but I also agree that they might have done the opposite. His article is all about saying the UK is not immune from the possibility of a debt crisis, so we needed to take out insurance against that possibility, and that insurance was austerity.
In spirit of Rogoff’s article, I want to acknowledge a couple of points. First, it is clearly too easy to argue that the Euro did not collapse, or that the UK had no problem funding its debt (quite the opposite), and so precautionary austerity was unnecessary. You have to look at the risks ex ante, and not at what happened ex post. Second, it would also be dangerous to argue that somehow UK history meant we were immune from these risks. Others more knowledgeable can argue over the extent to which the UK government has defaulted in the past, but they should never lead us to assume that the UK is immune from a market panic.
So let us agree that it was possible to imagine, particularly in 2010, that the markets might stop buying UK government debt. What does not follow is that austerity was an appropriate insurance policy. No one sensible disagrees that the government needed to have a credible long term plan for debt sustainability, and I personally have argued that a good plan should involve reducing net debt very gradually to levels below those observed before the recession. I hope Rogoff would agree that in the absence of any risk coming from the financial markets, it is optimal to delay fiscal tightening until the recovery is almost complete. The academic literature is clear that, in the absence of default risk, debt adjustment should be very gradual, and that fiscal policy should not be pro-cyclical. So the insurance policy involves departing from this wisdom. This has a clear cost in terms of lost output, but an alleged potential benefit in reducing the chances of a debt crisis.
Seen in this light, the first point to note is that – unlike most insurance – the benefits are partial and ill-defined. Austerity might make the markets less likely to turn on you, but it clearly does not guarantee that they will not. It is also quite reasonable to suggest that – to the extent austerity delays the recovery – it might make markets more rather than less worried about long term debt sustainability. So this is an insurance policy with a large cost, and a very unclear benefit.
What the Rogoff piece does not address at all is that the UK already has an insurance policy, and it is called Quantitative Easing (QE). QE means that the monetary authority is committed to keeping long term interest rates low, so they will buy any government debt that cannot be sold to the financial markets. Rogoff says that, if the markets suddenly forsook UK government debt “UK leaders would have been forced to close massive budget deficits almost overnight.” With your own central bank this is not the case – you can print money instead.
Now pretty well everyone agrees that printing money to cover unsustainable budget deficits is inflationary. But that is not what we are talking about here. We are talking about a government with a long term feasible plan for debt sustainability, faced with an irrational market panic. In those circumstances, printing money will be purely temporary, for as long as the panic lasts. As it is taking place in the depth of a recession, it will not be inflationary. So, as I argued long ago, Quantitative Easing is our insurance policy against a debt crisis. We never needed the much more costly, far inferior and potentially dubious additional insurance policy of austerity.