Wednesday, April 17, 2013

Is the academic premise for austerity in the eurozone crumbling? Not quite…

A mini-storm has been whipped up in the economic community overnight after a paper was published highlighting some flaws in the widely cited Reinhart & Rogoff paper ‘Growth in a time of debt’.

A quick recap for those of you not familiar with the paper. It essentially argues that high debt levels are associated with low economic growth. It bases its analysis on data from 44 countries over the past 200 years. It also notes that this relationship gets stronger once debt exceeds 90% of GDP. The paper has been widely cited in defence of and in support for ‘austerity’ – by politicians in both the US and Europe (notably Olli Rehn in respect to the eurozone crisis).

The new research released challenged Reinhart & Rogoff’s (R&R) findings, on the basis of an excel error (oops), data omissions and incorrectly weighting of data. There has been plenty written about which side is correct – you can see a summary of criticisms here and R&R’s responses here and here.

The question that interests us is not necessarily the intricacies of this academic back and forth. To be honest, it is obvious that there is no clear single threshold above which debt begins to impact growth in all countries and that often specific historical experiences in certain countries may not mean much for policies in different times and places (see this Ed Hugh post for a good summary). This is particularly true given some of the unique constraints of the eurozone crisis.

But given that some people are seeing this as a damning indictment of the backing for ‘austerity’, will this have any impact on the approach to the eurozone crisis?

In a word, no. Here are a few reasons why:
  • R&R research aside it is clear to everyone that Greece, Portugal and Ireland were insolvent, it was market pressure that pushed them into a bailout. Reducing the debt level is a vital part of their reform, while it also serve to counter the significant moral hazard that comes with a bailout.
  • Similar constraints apply in Spain, Italy, Cyprus and Slovenia. With elevated borrowing costs they cannot expand fiscal policy without coming up against greater market pressure and pushing their average interest costs well above their growth rates (especially in the short run).
  • Therefore, arguing for the end of austerity in these countries is actually arguing for fiscal transfers from the rest of the eurozone, since they do not have much, if any, room to expand spending. This is ultimately where the debate is at, it is not about austerity or spending, it is about whether the stronger countries are willing to provide the transfers – be it through banking union or fiscal union – to keep the eurozone together in the longer run and create the architecture necessary so that it can withstand future shocks. If they are not then they have to face the prospect of breaking up or decreasing the size of the eurozone.
  • The constraints which apply also extend much further than just public debt. As we have seen in Spain, Ireland and Cyprus (and are seeing in Slovenia) the levels of private sector and banking sector debt are equally important. The macro picture is much more complex than just the level of public debt and economic growth. The problems in the crisis are a mix of fiscal, banking and structural.
  • Austerity is more than just cutting spending. It has become a catch-all term for some very necessary reforms to improve competitiveness and productivity in the eurozone. Even if spending could be increased, these reforms would be needed, although admittedly the fallout (increased unemployment in many cases and massive political backlash) might be more bearable – but as noted above, this isn’t really possible in many of the worst cases.
  • The logic behind the current approach is also strongly driven by Germany’s own economic experience in the late 1990s and early 2000s, which proved very effective in turning the country around. The main issue here is not whether the approach itself is correct or not (since it clearly did work there), but the scope in which it is applied. It is clear that you cannot have 17 Germanys with economies driven by exports in a single currency bloc where the countries predominantly trade with each other (it might help in the short term but its not clear it is a sustainable long term economic model for the bloc).
So what academics (and policymakers) really should debate is whether fiscal transfers are possible and/or desirable.  Proving or disproving R&R is neither here nor there when it comes to dealing with the eurozone crisis.

6 comments:

Denis Cooper said...

How much does it matter what degree of "austerity" would be best for sorting out the economies of the distressed eurozone states?

The primary purpose of "austerity" is not economic but political, to permanently cow the peoples of those countries by teaching them a lesson that they won't forget for generations.

It matters not a whit that the peoples of those countries could no more prevent their politicians abusing the opportunities afforded by sharing a currency with Germany than the German people could prevent their politicians allowing them those opportunities in the first place, against all economic sense; the German people are entirely in the right and the others are entirely in the wrong; so those others must be punished, and however severe the punishment turns out to be it will be no more than they deserve in the eyes of the German people.

christina speight said...

There is NO possible justification for any austerity imposed by diktat from outside.

If a country cannot pay its debts , it cannot pay its debts - obvious, I'd say. So it is bankrupt and must then devalue and possibly impose temporary austerity, which in the eurozone it cannot. Result eventual chaos.

We are well on the road to that chaos

Anonymous said...

You write "austerity is more than just cutting spending". But here we have one problem I hate with most economists, especially modern macro guys. You tend to confuse what normal people understand austerity means and what economists and politicians mean by it.

Politicians and most economists think austerity means balancing budgets by increasing taxes. It's what most euro countries did. Cutting spending significantly never played a big role, neither did increasing efficiencies of the spending.

As far as I know perhaps only the Baltic countries did follow the austerity by reducing spending strategy. The rest train wrecked their economies with more taxes or with none existing cuts like in great Britain.

Anonymous said...

That's great, austerity which
literally kills people through
health and welfare cuts, as well as
destroying the long-term future
of the nation through education
cuts, is - according to Open
Europe Blog - actually a
catch-all term which includes
some "very necessary" reforms.

Jesper said...

The debacle should make it clear that economics is not to be considered a serious science.

If it was a serious science then their paper would have been peer-reviewed and it should not have passed.
If it was peer-reviewed and passed then one must wonder how it passed (passed based on the reputation of the authors?).
If it wasn't peer-reviewed then it is not serious science.

Rik said...

Like the IMF negative multiplier paper also this one was methodologically simply rubbish.

But at the end of the day OE asked the key question:
'where should the money come from to do otherwise?

Transferwillingness looks, see Cyprus, to be in decline and the ECB cannot act as this would be an obvious breach of the treaty.

Analysts simply donot seem to get that. Journalist and a lot of politicians for whom it is obviously way above their head as well.