Austerity is an integral part of the Greek tragedy

Too many people, including many in the Troika, see the Greek struggle as just about transfers from one debtor nation to lots of creditor nations. That is why they perhaps saw the Greek referendum as an unhelpful move, as just inflaming nationalist sentiment. As Dani Rodrik puts it “What the Greeks call democracy comes across in many other – equally democratic – countries as irresponsible unilateralism.”

It is, however, not just about transfers, or what economists call a zero sum game. It is also fundamentally about austerity, as Dani Rodrik, Thomas Picketty, Heiner Flassbeck, Jeffrey Sachs and I say in this letter jointly published in the Guardian, Le Monde, The Nation and Der Tagesspiegel (and thanks to Avaaz for making this happen).

I think many people believe that a debtor country must somehow inevitably suffer large scale unemployment as a result of having to pay back at least some of its debts. But this comes more from a moralistic view than thinking about the macroeconomics. In an open economy, the real exchange rate (competitiveness) will adjust to ensure ‘full employment’ is preserved, whatever primary surplus (taxes less non-interest spending) a government needs to service and pay back its debt.

Under flexible exchange rates this competitiveness adjustment could happen immediately. Things are not quite so simple in a monetary union: competitiveness cannot immediately adjust because of wage and price rigidities. A period of ‘excess unemployment’ will be required to push wages and prices down if the country is uncompetitive in relation to required primary surpluses. However the excess unemployment can be relatively modest. In fact, because of the structure of the standard Phillips curve, it is much more efficient to achieve gains in competitiveness gradually through a measured increase in unemployment than quickly through a rapid rise in unemployment, for reasons I outlined here when talking about Latvia.

To achieve this efficient outcome may well require the government to reduce its primary deficits gradually, because without this fiscal support while competitiveness adjusts output could fall rapidly. This in turn will require more government borrowing, and if the government cannot do this from the markets, the IMF or other governments should step in to ensure this efficient adjustment can take place and avoid the waste and suffering of unnecessary unemployment.

This is what failed to happen in the case of Greece. Whether this was just the result of poor Troika calculations, or a consequence of feeling that creditor bankers were more of a priority (see, for example, Mark Blyth), need not concern us here. Once the mistake became clear, perhaps creditor voter fatigue meant additional loans were not politically possible. But to demand primary surpluses (i.e. to take money out of the country) while unemployment remains so high - as the Troika continues to do - is unforgivable in my view. It clearly makes the unemployment problem worse - see here, footnote [2]. At best it indicates an impatient creditor with no concern for the welfare of the debtor, but given the responsibility the creditor has for the debtor’s current position it is far worse than that.

That is not the only reason Greece’s story is about austerity. Its problems were made worse by the austerity across the Eurozone as a whole, and the deflation which that has brought. Deflation increases the real value of nominal debts. It also makes competitiveness adjustment more difficult because of a well known non-linearity.

Even those that have a great dislike or distrust of Syriza should recognise that Syriza is also a product of acute austerity, a point which the referendum reaffirmed. As economists might say, Syriza is endogenous.

That the Greek economy now lies broken is not the inevitable result of imprudent borrowing a decade ago, or structural weaknesses, or a left wing government elected just a few months ago. It is also the result of the actions of those who effectively ran the economy from 2010 to 2014, and their imposition of draconian austerity. Greece long ago recognised the folly of its borrowing, and has made a start on addressing its structural weaknesses. The Troika has yet to acknowledge its own part in making this tragedy.

Greece and primary surpluses

In my simple guide to the current macroeconomic position of Greece, I said that a major mistake made by the Troika was to insist on a pace of fiscal adjustment that was far too fast. It led to a collapse in the economy. Of course a collapse in the economy itself raises the deficit. So people who just look at the deficit, including many comments on that post, say ‘what adjustment’ and ‘just how many years does Greece need’.

It is easy to avoid this trap. The OECD publishes a series for the underlying primary balance, which is their guess at what the primary balance (taxes less spending excl. interest payments) would be if the output gap was zero. It is the first row in the table below: the estimated output gap is below. I’ve also shown the scale of the decline in GDP, just to show that the output gap numbers are pretty conservative. Unemployment in Greece is over 25%, and over half of all young people are unemployed.

	2009	2010	2011	2012	2013	2014
Underlying primary balance (% of GDP)	-12.1	-6.0	-0.7	2.9	6.7	7.6
Output gap (%)	4.3	0.2	-7.1	-11.6	-14.2	-12.7
GDP growth (%)	-4.4	-5.3	-8.9	-6.6	-4.0	0.8

2009 was the peak underlying primary deficit, and it was huge, representing the actions of a truly profligate government. However what followed was complete cold turkey: within two years the underlying primary balance was close to zero. A pretty conservative estimate for the impact of fiscal consolidation would reduce GDP by 1% for each 1% of GDP reduction in the primary balance. In those terms, all of the current output gap in Greece can be explained by austerity.

As I have always said, some period involving a negative output gap was inevitable because Greece had to regain the competitiveness it lost as a result of the previous boom fuelled by fiscal profligacy. But slow gradual adjustment is more efficient than cold turkey. Paul Krugman explains one reason for this: resistance to nominal wage cuts. But there is another which is even more conventional. If we have a Phillips curve where inflation expectations are endogenous (either through rational or adaptive expectations) rather than anchored to some inflation target (as Paul implicitly assumes), then competitiveness adjustment can be achieved with a much lower cost in terms of the cumulated output gap if it is done slowly. (I gave an example here, then reacting to the idea that Latvia’s cold turkey adjustment had been a success.)

There are only two serious barriers to this more efficient adjustment path. The first is the willingness of some outside body to provide the loans to fund the gradual reduction in the government’s deficit. The second is getting those outside bodies to recognise this basic macro: austerity hits output, and gradual adjustment is better. I think the second turned out to be the crucial problem with Greece: as has been extensively documented, the Troika were hopelessly optimistic about the impact cold turkey would have.

So it is as clear as it can be that the current dire position of the Greek economy is the result of a huge mistake by the Troika. The size of the collapse in the Greek economy is similar to the fall in Irish output during the Great Irish Famine of 1845-53, and while the suffering in the latter is obviously of a different order, the attitude of some in the Eurozone is as misconceived as most English politicians during the famine. Of that event they say 'God sent the blight but the English made the famine'. In the future the Greeks may justly say ‘our politicians caused the deficit but the Troika made the depression’.  

Growth vindicates Greek Austerity

I cannot resist quoting from this editorial in today’s Greek edition of the FT.

Greek government and Troika’s austerity policy vindicated

Since unveiling its austerity strategy to reduce its yawning budget deficit in 2010, the Greek government together with the Eurozone’s Troika has faced immense pressure to change tack. An alliance of Keynesian economists and opposition parties has accused them of choking off growth. The prophets of doom predicted years of stagnation with soaring unemployment and falling living standards.

After a run of positive growth numbers this year, the Greek government and Troika have reason to feel vindicated. They have won the political argument. True, the Greek economy is still a quarter smaller than its pre-crisis peak. But the current acceleration looks like the beginning of a sustained recovery. The anti-austerians grumble that the upturn would have come earlier had the Greek government and Troika eased up on the fiscal squeeze. This is impossible to prove as economic history offers no counter-factuals. What we do know, however, is that the critics overstated the obstacles standing in the way of a recovery. Their position was too extreme and they have found themselves snookered.

OK, the FT here is the Fictitious Times, but otherwise I have kept pretty close to the beginning of this real Financial Times editorial about somewhere else. The numbers may be different, but the reason why this editorial would be ridiculous are exactly the same as why the original editorial was. And yes, I know I have complained about it a few times, but because the FT is a quality financial paper that generally gets things right, and which other journalists look to for economic expertise, it is important not to forget the occasional lapse from otherwise high standards. And the FT are not the only respected economists who sometimes mistakenly treat growth from a deep recession as an indicator of a successful policy.

What is it about Latvia?

                that either makes visitors lose their critical faculties, or non-visitors like myself and Paul Krugman lose theirs. In my earlier post, I was not that surprised that a member of the ECB’s Executive Board would trumpet Latvia’s ‘success story’, because that fitted the party line. I was a little more surprised to find the head of the IMF saying similar things, because the IMF has been rather more realistic about the consequences of austerity and internal devaluation. (Although the contrast between the IMF’s recent UK assessment in writing, and what Lagarde said in public, was widely noted at the time). What really surprised me was this post from Dani Rodrik, who has also just visited Latvia.

                Dani Rodrick’s post goes into more detail about recent Latvian macroeconomics. In particular, he suggests that despite the massive decline in GDP and huge rise in unemployment, the economy may still have not completely regained the competitiveness they lost in the preceding boom. So, in terms of the evidence, he sees what I see if not worse. But then he says this.

“The main lesson I take from all this is the need to avoid easy generalizations that do not respect country peculiarities. Fiscal austerity missionaries are surely off base when they say Latvia’s experience decisively proves Keynesians and advocates of currency depreciation wrong.  It is too early to judge the Latvian experience a success.  But it is also too early to say Latvia has been a failure.  Growth may continue, in which case the country will look better and better.”

                When someone like Dani Rodrik looks at the same facts, but comes to rather different conclusions than me, I get worried that perhaps I’m wrong. It is also wise to heed Brian Ashcroft’s warning, that small countries do have different characteristics to larger countries. With this in mind, let me go through some of my own macroeconomic reasoning carefully.

                Was the depth of the recession inevitable given the preceding boom? Paul Krugman is perhaps a little too dismissive on this point. The economy clearly was overheating in 2007/8, which is why it became uncompetitive. At the very least, inflation had to come back to a reasonable level. In principle this need not require any subsequent deflation if we have a totally credible macroeconomic policy, a suitable devaluation and a completely forward looking Phillips curve, but that is an idealisation. So some recession was probably inevitable, as it has been for many Eurozone countries. But in 2008/9 Latvia suffered the worst loss of output in the world!

                The key issue is not that Latvia had to get inflation down, but that having done that it also needed to regain competitiveness. It is here that the macroeconomics of a short sharp recession with a fixed exchange rate looks so bad. To see why, think of the following little experiment.

                We have an economy, which through overheating has become uncompetitive. It needs to get its prices in Euro terms down by, say, 20%. The government has dealt with the overheating: the output gap is now zero and inflation is at its competitors’ level. But prices are still 20% too high.

                The least cost option is to devalue the currency by 20%. Now it would be foolish to believe that is all you need to do. Restoring competitiveness will boost demand, so to prevent the overheating starting up again you need to undertake deflationary policy of some kind. You may also need some negative output gap because higher import prices will raise price inflation. However you do not need a 20% decline in output.

                But suppose we take the fixed exchange rate as given. Even in this case, a short sharp recession makes no macroeconomic sense. Suppose that, for given inflation expectations, a 1% output gap will reduce inflation by 1%. A short sharp shock of output 20% below potential for a year will give you -20% inflation in that year, so you will have restored competitiveness quickly, but at great cost. Now think about spreading the correction over two years.

                To see how that works, we need to say a bit more about the Phillips curve. As we discovered in the 1970s, inflation today depends not just on the output gap, but also expected inflation. Suppose our Phillips curve is of the modern New Keynesian kind, so this year’s inflation rate depends on next year’s expected inflation, and let’s assume people are pretty rational in forming their expectations. What if we have an output gap next year of -10%. This will mean that inflation next year will also be -10%. But this year we do not need any output gap at all. Inflation will still be -10%, because expected inflation is -10%. So we get our competitiveness adjustment over two years, but at half the cost in terms of lost output.

                Is my assumption about rational expectations critical here? No. Imagine instead that the Phillips curve is of the old fashioned kind, where expectations are naive and backward looking, so current inflation effectively depends on past inflation. In this case we need an output gap of -10% this year, but then nothing next year, and we still get our correction over two years at half the cost. (We have to do something to get inflation back up after two years in this case, but that is not important to the point I’m making.)

                Now this is all very stylised and partial equilibrium, but there is one important message that will survive complications. The Phillips curve tells us that reducing the price level gradually over time is more efficient than doing it quickly. So even if you believe that you have to stick with a fixed exchange rate, a short sharp recession is much less efficient than a more modest but prolonged recession. Thinking about the convexity of the social welfare function reinforces this point.

                As a result, even if output growth this year and next year was over 5% p.a., and the country achieves a sustainable level of competitiveness, I would not call the Latvian experience a success story. The competitiveness correction will have cost the economy a huge amount in wasted resources and unemployment misery, when it could have achieved this correction at a much reduced cost.

                

Why cannot other European countries show this courage?

                The outcome of the ECB meeting yesterday was rather more positive than I had hoped. Why? Because the decision to do nothing was not unanimous. That’s it I’m afraid, but my expectations beforehand were very low. One reason was reading this short speech by Jörg Asmussen, a member of the Executive Board of the ECB. (HT P O Neill) It was delivered in Riga, and extols the path of internal devaluation and austerity taken by Latvia.

                Let me quote, to give you the flavour. “From 2008, Latvia was faced with the deepest recession in the world. The cumulative output decline was 24%; unemployment peaked at 20%. Keeping the euro peg was considered by many as a “mission impossible””. “External devaluation was presented as the only way forward. But Latvia did not choose the easy “quick fix”. It embarked on a courageous fiscal consolidation path and structural reforms. Two years later, the speed of the economic rebound is as extraordinary as the depth of the recession. Against all the odds, Latvia recorded a real GDP growth rate of 5.5% in 2011.”

                An extraordinary success story: after an 18% decline in GDP in 2009, and flat GDP in 2010, we now have 5.5% growth in 2011. But surely I’m being economical with my quotes here. Isn’t the 5.5% growth last year just the beginning, with the economy achieving a new dynamism. Mr. Asmussen does not provide any additional evidence on this. Perhaps wisely, as the IMF are predicting 2% growth this year, and 2.5% next year. So the 5.5% growth last year is all we have.

                Mr. Asmussen could have talked about unemployment, which has also fallen rapidly, from a peak of 20% to 15% currently. Perhaps he did not, because unemployment shows more clearly what has actually happened. We have had a huge recession, followed by a much more modest recovery. And, as we might guess, there is apparently much more talk about structural unemployment in Latvia today. For a rather more objective account of the Latvian experience of internal devaluation, see this (US) CEPR study, or a number of Paul Krugman's posts.

Earlier this year I wrote that when growth returned, some would say this proved those pessimistic Keynesians had been all wrong. I must admit the ‘some’ I had in mind were politicians and journalists, not senior central bankers. By this logic, an even better strategy is to close the whole economy down for a year. The following year we could get fantastic growth as the economy starts up again.

But the really scary thing about this speech is the lesson Mr. Asmussen draws from Latvia’s ‘success’. “The Baltic experience shows clearly that speed is of the essence. In all three Baltic countries, the government reacted swiftly to the deterioration of public finances and frontloaded fiscal adjustment. With a budget consolidation of around 9% of GDP in 2009 alone, Latvia’s effort is unparalleled in Europe.” So, Ireland and Greece, you know where you went wrong. You have been far too tentative with your austerity.

The language is indicative. We have a “courageous fiscal consolidation path”, “it is better to take the medicine right away than to let the fever rise for months”, and “Latvia’s effort is unparalleled”.  Perhaps we can describe this as ‘masochism macroeconomics’. Or is it faith in the macroeconomic afterlife: penury (a massive waste of resources) today bringing virtue (austerity and structural reform) that promises redemption (wealth creation) in the distant future.

So this is why I was pleased to hear that the ECB’s decision had not been unanimous. At last, some policymakers in Europe do not believe this dangerous nonsense any more. 




Postscript. Mark Weisbrot at the Guardian alerts us to Christine Legarde singing from the same script, alas.