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.

Keeping quiet about hidden motives?

This is about UK politics, but it involves a wider point that applies in all countries where austerity policies are being justified by the need for immediate deficit reduction  

John Rentoul, chief political commentator for The Independent on Sunday, liked my Prospect debate with Oliver Kamm. To quote:

“I found it usefully clarifying. I started off on Kamm’s side, because I worry about running a huge deficit in case interest rates return to normal. But Wren-Lewis makes a convincing case for worrying about that later, although he threw away some of his advantage at the end by suggesting George Osborne has an ulterior motive for cutting public spending, namely the ideology of a smaller state. Who wants the state to be larger than it need be?”

There is an awful lot I could talk about in that paragraph, but let me focus on the ulterior motive point. [1] First the bit of my argument that Rentoul is referring to.

“Why is this government proposing to repeat past mistakes, and embark on a policy that makes so little sense in terms of the macroeconomics taught to students around the world? As an academic I have tried and failed to find a macroeconomic logic to what the government is proposing. Could it be that in reality the deficit is a smokescreen to hide the underlying goal, which is a smaller state? The British people do not want a smaller state, so the only way it can be achieved is by maintaining the myth that reducing the deficit is our top priority. The government can only get away with this myth as long as enough of the media, with the help of City economists, support it.”

Let me be honest here. I did think twice before writing this, because I knew it might evoke a negative reaction among some who read it. Why not, as Rentoul suggests, just stick to the ‘no macroeconomic rationale’ point?

Before directly addressing this, let me draw an analogy. Here is a piece by Jeffrey Sachs in the FT about climate change which on this occasion I’m happy to agree with. He does not waste time with a point by point refutation of everything that climate change sceptics put forward. Here is his conclusion:

“At the end of the day, we have a classic story of political economy. There is a very concentrated but very weighty interest group with an interest in finding and pumping oil, and then there is the rest of humanity, with an interest in a rapid transition to a low-carbon future. The interest group owns Congress and much of the airwaves; it moves election results in Australia and Canada, two other carbon economies; it drives politics in the Middle East and Russia. Politics is often a close call. This one – for the survival of the planet – is going down to the wire, with a crucial rendezvous in Paris at the end of the year.”

Now you might equally say on this occasion why taint a perfectly good scientific case about climate change with conspiracy theories about oil interests? There are two excellent reasons. First, the trouble with debating the 'scientific' arguments of this interest group at face value is that it gives the impression that there is genuine debate going on, and that the key facts about climate change are controversial in scientific terms. That is nonsense, but it is also exactly the impression that this interest group wants to create. Most people will not go through the science and realise that the sceptics case is virtually non-existent. Instead they will think the science is controversial, and so go with their instinct, or with whatever those who support their politics advocate. This is why the US has an unusually low number of people who think climate change is a major threat. Second, I think social scientists have a duty to explain the world as they see it, and not hide these truths away because it might be too much for some.

Of course climate change and austerity debates are not completely comparable for many reasons. However when it comes to the macroeconomics of Osborne’s policy, I think we have now reached a similar point. Back in 2010, there was an arguable case for rapid deficit reduction, particularly as the source of the Eurozone crisis was unclear. In 2014 we know a lot more. Let me justify that with three arguments.

First, the paragraph I wrote is quite truthful in describing my own thought process. I have searched hard to find a macroeconomic rationale for Osborne’s policy stance. A belief that QE is as effective as conventional monetary policy (there is no liquidity trap) comes close, but as I explained here it does not really fit with what Osborne has said (or not said). Osborne is certainly no market monetarist, as he has shown no interest in nominal GDP targeting. So there does not appear to be a coherent case for Osborne’s fiscal proposals that a macroeconomist could take seriously.

Second, the idea that the real motive is a small state is not the preserve of some small group of left wing conspiracy theorists. Here I quote Jeremy Warner, economics editor of the Telegraph (for non-UK readers, a newspaper firmly to the right): “In the end, you are either a big-state person, or a small-state person, and what big-state people hate about austerity is that its primary purpose is to shrink the size of government spending.” He also wrote: “The bottom line is that you can only really make serious inroads into the size of the state during an economic crisis. This may be pro-cyclical, but there is never any appetite for it in the good times; it can only be done in the bad.” I also think many of my non-UK readers will wonder why I am having to justify what is obvious in their countries.

Third, it must have become clear to many people now that reducing the deficit cannot be the overriding priority when there have been so many tax giveaways (50p rate, Help to Buy which creates large contingent liabilities, Cameron’s conference commitments, stamp duty changes that are far from fiscally neutral, pensioner bonds). Putting these down to ‘politics’, but counting spending cuts as ‘economics’, will not wash. (See Brad DeLong for the equivalent in the US). You cannot pretend that deficit reduction is driving government policy, when that driver only operates on the spending side of the accounts.

Economists in the media are beginning to realise this. It is really important that political commentators do so as well, so that those without an economics background get a clearer idea of the nature of the choices they will have to make in 100 days time.

[1] Who wants the state to be larger than it need be? I couldn’t agree more, but then each state activity should be examined on a case by case basis. Osborne’s cuts are not based on analysis of that kind, because it presupposes the result (there have to be cuts of a certain size). 

Sachs and the age of diminished expectations

I do not normally talk much about the US economy, because there are so many others writing articles and posts that can do so with more authority. But I am getting increasingly fed up with people telling me that US growth disproves the idea that austerity is bad for you at the Zero Lower Bound (ZLB). Jeffrey Sachs just joins a long list.

Of course the proper way to tackle this is as Paul Krugman does. As he says other stuff happens (like a large fall in the US savings ratio in 2013), so you need to go beyond a single country and look at lots of data. However this might leave the impression that somehow the US case is unusual and does not fit a Keynesian story. In this respect I did a simple exercise, the results of which are shown in the chart. It shows actual US GDP, and a hypothetical path based on 2% real growth in government consumption and investment from 2009. So instead of austerity, we maintained government spending at the elevated levels seen at the bottom of the recession. In addition I’ve assumed quite a large (and instantaneous) multiplier of two on that extra government spending.

US GDP, billions of chained 2009 US dollars.

Now if the US recovery proved that Keynesian analysis was wrong, we should get nonsense out of an exercise of this kind. If the recovery was just fine with austerity then replacing it with something like fiscal stimulus and assuming a large multiplier should give us ridiculous rates of growth. Yet as you can see, the no-austerity GDP path looks perfectly plausible. What we get is 3.4% growth in 2010 (compared to an actual of 2.5%), followed by three years of 3.7% growth (compared to 1.6%, 2.3% and 2.2%). In other words we get a reasonably rapid recovery from a deep recession. Obviously there are more sophisticated ways of doing this kind of counterfactual, but maybe something very simple can make the point. With recent US experience, there is no case against Keynesian analysis to answer. 

This suggests to me two things. First, lots of people are desperate to show that critics of austerity at the ZLB are wrong, and are prepared to make nonsense arguments to that end. This may be particularly true if you very publicly proclaimed the need for austerity in 2010 (note the co-author: HT John McHale). Second, it is a sad day when anyone thinks that 2.3% growth is “brisk” when we are recovering from a deep recession and interest rates have remained at the ZLB. It is so very dangerous when these diminished expectations become internalised by the elite.     

The Unlikely Friends of Austerity

Sometimes economists who support austerity have clear ideological or political motives. However I often come across economists who do not have these motives, and yet are deeply suspicious of the idea of Keynesian stimulus. In other words, they are economists who are quite happy to acknowledge market failure, and embrace the idea that governments have an important role in helping to correct that failure, and yet they are unhappy with what Jeffrey Sachs calls ‘crude Keynesianism’. (For a detailed critique of this Jeffrey Sachs piece, see this post from Mark Thoma.)

Where does this suspicion come from? Often there seems to be a view that the austerity/stimulus debate is a distraction from focusing on more important, longer term problems. Oddly this view is asymmetric: I do not think anti-austerity economists deny that there are also important longer term problems. I also think longer term issues are more difficult to fix at times of austerity, so in that sense the short and long term solutions are complements, not substitutes. There is the notion that some have that we need a crisis to get things done, but perpetuating and mis-diagnosing the crisis is precisely what those who want to use debt scare stories to reduce the size of the state are trying to do.

A particular and important example is a concern about high or rising government debt. Government debt is almost always a long term problem, whereas deficient demand should just be a short term problem. As regular readers of this blog will know, my current views about the (un)desirability of government debt in the long run are quite radical, but I have no problem combining this with a belief that in certain circumstances fiscal policy should be used to stimulate (or in the Eurozone, also cool down) the economy. [1]

There is an understandable concern about debt and markets. That concern should not be dismissed lightly. I remember being asked by economists working for the UK government in 2009 just how far can we let debt rise before markets panic? I knew that my answer, which was that in a balance sheet recession there was a higher demand for government debt (particular when it was accompanied by a flight to safety), was based on a solid macro model. But though I thought the chances of my being wrong were small, I also knew the costs of my being wrong could be very high, which should make anyone cautious. Now I am much more confident, because events have vindicated the model. [2] However I recognise that some people are hyper risk averse, or believe markets are totally fickle, which is partly why I have always stressed that fiscal expansion can be done without issuing more debt. So if this is your real concern, become an advocate for balanced budget fiscal expansion or other, more innovative, changes in the fiscal mix.

I suspect an equally important reason why economists are sometimes unenthusiastic about fiscal stimulus is that they have been trained to misread the problem we are currently dealing with. This is not just the idea that monetary policy rather than fiscal policy is the stabilisation tool of choice. More fundamentally, it is the line promoted - consciously or unconsciously - in almost every textbook that economic downturns are ultimately self correcting. We have a business cycle because prices are sticky, but eventually prices are flexible, so we are bound to get back to full employment once prices adjust (which cannot be that long).

The best thing to say about this message is that it is incomplete. It should say that what gets us back to full employment is monetary policy. Having an appropriate monetary policy is a necessary condition for returning to full employment. A monetary policy that, for example, kept real interest rates constant would not get us back to full employment following a permanent negative shift in aggregate demand. The moment you understand this, the seriousness of the zero lower bound coupled with inflation targets (which put a lid on inflation expectations) becomes apparent. We are not dealing with a normal recession that will end pretty soon, we are dealing with something that could last much longer.

So for someone like me, what I see at the moment is very simple. We have demand deficiency, and the normal means of correcting it is broken. We luckily have a backup system, but the levers of that system are being pushed in the wrong direction. What is worse, this backup system is not some mysterious or controversial mechanism - it is what we teach to students day in and day out. So to push the levers in the wrong direction just makes a mockery of macroeconomics.


[1] There is a concern about transition and persistence. That fiscal expansion today will be politically difficult to undo, and so will increase the longer term political challenge. I think that is one good reason for focusing on government spending rather than tax cuts or transfers, and more specifically on government investment, in any stimulus package. There are of course other good reasons for doing this.

[2] And because we have Quantitative Easing.