Thursday, 17 May 2012

The Fruits of European Austerity


                In an earlier post I argued that austerity in Eurozone countries like Ireland was not necessarily self defeating, if those governments were put in a position where they had to convince markets that they would not default. Even if DeLong and Summers were right that austerity would eventually raise the debt to GDP ratio, this was not the key issue for default risk. John McHale makes a similar point. In this post I want to add two important caveats to this argument, which I can label Spain and Greece.
                Spain first. Most of the discussion of austerity focuses on the government’s budget constraint. However, when it comes to default risk in Eurozone countries, it may be more appropriate to look at the consolidated balance sheet of the government and banking sectors. A good proportion of the banking sector in countries like Spain is fragile because too much was lent before the recession. Because this proportion is large, these banks will be seen as too important to fail, and so the government will bail them out at some point, which is why the consolidated balance sheet becomes relevant. (It is the lack of a banking union, rather than a fiscal union, in the Eurozone that is arguably the major problem, as Vallee suggests.)
                If this is the case, then we need to rethink whether austerity can actually make the current position worse. When looking at just the government, the impact of cutting spending on the deficit is very unlikely to be offset by lower taxes or higher transfers generated by lower output – multipliers would have to be extremely large for this to happen. However, when lower output generates falls in asset prices and adds to personal or company liquidations, this could make a big difference to the solvency of highly leveraged banks. If the government is going to have to bail out these banks as a result, then it would be entirely rational for the market to raise interest rates on government debt following additional austerity measures. (I will not get into how markets actually do react: when there is a lot of noise, it is too easy for casual empiricism to cherry pick the data, as this post looking at recent events in the Netherlands points out.)
                That is one reason why austerity might be self defeating. The second, which is happening in Greece right now, is that austerity is pushed so far that it loses democratic support. Demonstrations of austerity designed to show that the government will not default become pointless if those demonstrations mean the government falls to others who would default. And allowing output to remain depressed as a consequence of austerity clearly does undermine the political centre.
                Some commentary, like this FT piece ($) by Lorenzo Bini Smaghi, suggests Greek voters are being irrational. Like Kevin O’Rourke, I disagree. I might even go further than Kevin. When debtors threaten to default, creditors always want to get their money back, but whether they can achieve this depends on how powerful the position of each side is. When the debtor is a government running a primary deficit, complete default does not look attractive because additional austerity will have to be implemented immediately, and creditors know this makes the default threat weak. However in this case the creditors' position looks at least as weak.  Politicians would have to explain to their already restive electorates why they have just lost a lot of money in their failed attempts to keep Greece in the Eurozone (or, indeed, why Greece was allowed in at all). More importantly, the analogy with Lehman’s looks appropriate. If Greece left the Eurozone there would be an immediate run on other ‘vulnerable’ Eurozone country banks, and here I agree with Lorenzo Bini Smaghi that the “contagion will be devastating”.
                Greek voters are also said to be illogical in wanting to stay in the Euro but not wanting austerity. Other Eurozone governments and European officials like to present it that way – they would, wouldn’t they. But it is unclear to me who exactly will do the deed of expelling Greece, if Syriza leads a government and interest stops being paid. Germany might be prepared to force a Greek exit, but following Hollande’s election I strongly suspect that they would not find a majority of countries supporting them. Too many would fear the consequences for themselves. Instead some compromise would be put on the table.
            Now we may never get to see this poker game play out. The rest of the Eurozone hopes that their show of contemplating Greek exit will convince Greek voters not to try and call their bluff. Alternatively, as Greek banks run out of money, the ECB may feel that it has no choice but to pull the plug on Greek banks, although I could imagine it is very reluctant to do this. Whatever happens, the moral of this story is that creditors have to be very careful when inflicting austerity on debtors. In some cases, like Ireland, they may succeed in doing so on quite painful terms, and the debts will be repaid. In other cases, they may go too far, with highly damaging results for everyone. It has happened before in Europe, as Miller and Skidelsky remind us.       
                

3 comments:

  1. I agree with a lot of what you're saying, but this is wrong:

    "...austerity in Eurozone countries like Ireland was not necessarily self defeating, if those governments were put in a position where they had to convince markets that they would not default. Even if DeLong and Summers were right that austerity would eventually raise the debt to GDP ratio, this was not the key issue for default risk"

    The problem here is that the investor's problem (to buy bonds or not) is a forward-looking problem. Conversely, you seem to be arguing that only the contemporaneous financial position matters. In the extreme case of Recardian Equivalence, the contemporaneous financial position of the country would matter not at all (since bonds are just deferred taxes).

    Even without RE though, the forward-looking problem of bond investors leans heavily on the growth-path of GDP (the government's ability to pay when the bond matures) and not on contemporaneous factors. If bond investors believe that they will be repaid by the time the debt matures than they will purchase the debt. This is especially true during a recession when opportunities for private investment have dried up--gov't debt is still a relatively safe option and time horizons are long (interest rates low).

    In short, if austerity depresses growth (in the medium or long run), it will be self-defeating even in the short run. Moreover because "short-run" is defined in terms of price adjustment, the "short-run" can in theory continue almost indefinitely (i.e. the adjustment via internal devaluation between Greece and Germany has been somewhere between painfully slow and non-existent).

    This can go wrong, of course, but it goes wrong in the De Grauwe multiple eq'a sense. The belief that gov't might default sends interest rates up which further depresses demand for bonds. Default is a self-fulfilling prophecy. It is for this reason that people like me argue that the central bank (ECB) must support fiscal expansions.

    This all being the case, and DeLong-Summers being right, means that austerity is (almost) always self-defeating. There would need to be an unusual set of parameter values (as in D-S) for it not to be.

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  2. I agree this is tricky, but the key point is that budget deficits have to be cut so that debt falls, and not so that debt just stabilises at a higher level. One of the reasons for default may be that it is politically impossible to achieve those debt reducing deficits. The sooner the government can produce those deficits, the quicker does it dispel these default concerns. Take a silly example. Suppose the government could, by running a huge surplus, bring debt down to an acceptable lower level in one year. Once it had done that, the deficit could increase again, to a level consistent with the new lower level of debt. The default risk premium would disappear after a year. Compare that with the case where it did the same over a two year period. That would require less of a surplus each year, and would hit output much less, but concerns about default would continue into the second year.

    Or take the worry that the government will default once a primary surplus had been achieved. The best way of reducing that concern is to run a primary surplus and not default. The quicker the government can achieve a surplus, the sooner the default premium on this account might fall.

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  3. I thought it was reckless of various high dignitaries to categorically rule out yielding to any of Syriza's demands. Do these people stop and think at all? If the Troika managed to browbeat the populists into submission, then the electorate will become even angrier and more radicalized. The troika would no doubt find it infinitely more preferable to negotiate with populists than extremists. Though I guess there would be a certain amount of schadenfreude in seeing Merkel facing off against Golden Dawn. Alas, I suspect a communist victory more likely (if the army will allow it).

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