The famous debt-to-GDP ratio has two components. To reduce it, you can focus on either cutting the debt (austerity) or increasing the GDP (stimulus). The former preference has prevailed until now, partly because it’s more intuitive and therefore easier to explain to voters. If your household racks up too much debt, you cut back on spending, so if a country gets too indebted, the solution is surely for it to slash expenditure too, right?
Actually, no. While appealing for its simplicity, the household analogy is flawed for the obvious reason that a country is not a household. It’s not just a matter of semantics —family finances and macroeconomics are as different as night and day. Spending less has no effect on your wage, so you can tighten your belt without jeopardising your income. Nevertheless, the impact of everyone cutting back at the same time is much worse because one person’s reduced spending results in another’s reduced salary.
Austerity has a few arguments going for it, though. Governments that borrow a lot suck most of the credit available, leaving the tap dry for the private sector. Businesses have trouble obtaining funding and the economy stalls as companies are starved of credit. Another powerful argument against high debt levels is that interest payments sap the government’s finances and strip it of funds that could otherwise be invested in something productive.
Keynesian economics, on the other hand, focus on the GDP part of the equation. The idea is that the public sector should act countercyclically, doing the opposite of whatever the private sector does in order to smoothen out the extremes of the business cycle. If both private and public slash expenditure at the same time, the compound effect is so damaging to the economy that the fall in GDP offsets any amount saved through austerity (i.e. the famous “fiscal multiplier” is greater than 1.0). On the other hand, rampant government spending when the economy is booming makes an asset bubble likely.
In theory, both austerity and stimulus make logical sense in a recession, but in practice our historical experience shows that stimulus is the way to go. The most glaring example is the Great Depression, when after years of asphyxiating austerity, US President Roosevelt and Japan’s Prime Minister Takahashi tore up the rulebook and blasted their countries out of recession. But today’s world also features such examples, chief among them America, which is consistently growing 3 percentage points more than Europe thanks to Obama’s stimulus plan and the Fed’s accommodating yet bold policies.
Moreover, the case for austerity is getting steadily weaker. Peripheral countries’ risk premiums have ballooned despite tough austerity measures. The IMF admitted that it got the fiscal multipliers wrong. And the Reinhart-Rogoff fiasco saw one of the pillars of the austerity consensus crumble.
A few holdouts remain. Britain’s Osborne and EU Commissioner Rehn have staked their credibility on the success of austerity and may be too stubborn to perform a volte-face. Angela Merkel is cultivating a tough image to appeal to her core electorate ahead of the upcoming election. However, a change of course is imperative for the sake of Europe and, ultimately, their own countries.
The aim of this piece is not to call for stimulus; lots of articles out there make a convincing case for it already. No, the objective is to debunk a couple of myths peddled by austerity supporters and Keynesians alike.
The first one is that “stimulus” is just a fancy word for careless spending: borrow or print lots of money, spend it and everything will be all right. It doesn’t work this way. Raising benefits and government largesse in general is very inefficient stimulus (it’s not that welfare is undesirable, it’s just that it’s not fit for this particular purpose). What “stimulus” means is investing in areas that will create jobs today and benefit the economy tomorrow: infrastructure, science, technological R&D, renewable power, energy efficiency measures, medical research... This is crucial: an investment with no positive effect beyond the immediate future is not stimulus, just more wasteful spending.
The other one is that Keynesian economics call for perpetual stimulus. It cannot be overstated that the choice of stimulus or austerity is a matter of timing: too much spending during a boom can be every bit as damaging as excessive tightening during a bust. Europeans need to accept that, once the economy is stable and growing healthily, we’ll have to switch from stimulus mode to debt repayment mode. We must be responsible and avoid punishing the governments that will eventually have to end the stimulus. We won’t have any gunpowder left for busts if we burn it all up during booms.
Austerity and stimulus are two different tools, both of which can be useful in the right situation. We need to break free of the “either austerity or stimulus” narrative because it limits us to either a hammer or a screwdriver. Yet, if it is to survive, the Eurozone will need every tool in the box.
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