Austerity is a pain. So is tight money





January 19, 2012

AUSTERITY in the euro zone has been under attack ever since the first economist representing the troika (IMF, ECB, EU) set foot on Greek soil. Actually, the troika may become more of a duoika (?), according to Athens News (via Tim Duy), because the one-sided emphasis on austerity is enervating the IMF.

I think this is as good a time as any to review why austerity could harm the economy, and whether there is a difference between regional austerity, and euro-zone-wide austerity. After all, some readers may wonder: should a highly indebted country stop saving?

The main argument for why austerity hurts the economy is that in times of insufficient aggregate demand, a further cut in government spending takes away the only player willing to borrow and spend instead of hoarding cash. However, the central bank has a big say in how much cash people want to hold and how much they are willing to borrow and spend. A recent IMF study on austerity confirms that monetary policy plays a large role in whether austerity hurts the economy or not. What follows in most economic theories (see Mankiw and Weinzierl or Woodford for recent treatments) is that government spending changes have only minor effects as long as central banks are unconstrained. Are they?

The central bank of a small open economy like Britain is almost never constrained because a policy of last resort, currency devaluation, is always possible—as the Swiss Central Bank recently demonstrated. Swedish economist Lars Svensson calls this “the foolproof way”. Therefore, if David Cameron’s austerity policies are hurting the economy, then the main reason is that there is either political pressure on an otherwise unconstrained central bank or technical obstacles that prevent it from stabilising aggregate demand appropriately.

The central bank of the euro zone is unlikely to be constrained, either. It could, at least in theory, counteract euro-zone-wide austerity and compensate for the shortfall in aggregate demand that such measures are likely to entail. Should it hit the zero lower bound, or should banks face unreasonably high funding costs despite low interest rates, the issue gets a little more complicated but is not necessarily unsolvable.

What about, say, Greece? After all, it doesn’t have a central bank with independent powers to set monetary policy according to its needs. Recent research suggests that government spending has a large effect on the economy in exactly these circumstances, in which monetary policy is not set at the national level but by a supranational or external authority. Austerity will therefore hurt these countries: at current levels of prices and wages, aggregate demand in Greece is insufficient, and fiscal austerity eats further away at it in the absence of a central bank to pick up the slack.

This seems like a trap for an over-indebted country in a currency union. And to some extent it is a real dilemma. However, it reveals three important lessons for governments, the troika and the ECB.

First, whenever governments or troika’s need to spend “political capital”, they should reconsider whether austerity gives the best debt-reduction bang for the political buck. Research suggests that austerity, besides its harmful effects in a currency union, is politically very costly. On the other hand, growth-promoting reforms are very difficult to implement as well, as the above Athens News article suggests. It really seems to be a political dilemma for which there is no easy way out. But the emphasis should be on growth-promoting reforms, not austerity, when there are political limits.

Second, when your competitive position is untenable there is no substitute for internal devaluation in a currency union. Of course, evidence indicates just how difficult internal adjustment really is. So the local inadequacy of aggregate demand at current levels of prices and wages consists of a temporary and a permanent part. The goals should be to deal with the unavoidable permanent part by regaining competitiveness, while limiting the temporary aspect, for instance by avoiding short-term austerity.

The permanent part seems to leave two options only: wage cuts in, say, Greece, or wage increases in Germany. The former is very hard, as we know. The latter, however, should not go so far as to erode the core’s competitiveness because this would simply imply a shuffling of insufficient aggregate demand around the euro zone (no, competitiveness is not a zero-sum game).

The solution to this problem (and this is point three) is that the ECB has to aggressively stabilise aggregate demand in the euro zone as a whole. This will counteract regional austerity in two related ways. If austerity is hurting one region of the economy because it further reduces aggregate demand there, the other parts need to experience excess demand that hopefully will make its way via trade towards the part suffering from austerity. Moreover, it will exert strong upward pressure on German wages and probably downward pressure on the euro, without eroding Germany’s competitiveness. This in turn facilitates the adjustment of wages in the periphery, as wage stagnation plus German inflation and a depreciation of the euro boosts external demand. One of the most under-appreciated aspects of this European crisis is that the ECB is currently failing to stabilise aggregate demand in the euro zone as a whole.

When it comes to austerity in Europe, therefore, the criticism is in part justified: it is harmful. Growth-promoting reforms probably have a better return on (political) investment. But it is important to point out that monetary policy is a major counteracting force to austerity, and failing to use it appropriately should not be blamed on austerity policies, but on the ECB. Unfortunately, this connection is much too often ignored. Some essays on austerity’s effects on growth don’t even mention monetary policy at all. It’s high time that this changes.

The Economist,