Austerity and TINA

In an interview with Spiegel Online the editor-in chief of The Economist, Zanny Minton Beddoes, made some derogatory comments on the German austerity approach towards Greece, and argued that there may be too many legally trained civil servants and a shortage of economists working in the Finance Ministry. This is definitely a wise insight but still puts an much too strong trust into the macroeconomic expertise of economists, not to talk of German economists who in the vast majority act and argue in favor of the underlying macroeconomic approach of the edstablished crisis management. Even if one would substitute the whole group of lawyers from the Ministry of Finance and substitute them with German economists, the outcome would not differ, as the Frankfurter Allgemeine Zeitung (FAZ) put it:’What should be wrong with saving?, meaning: what is wrong with austerity? Rather then citing again and again German mainstream economists the paper refers to Alberto Alesino who belonged to the small group of internationbal economists who were invited for a high-level symposium before the start of the G7-meeting to discuss global ecopnomy issues and in particular the case of Greece. I haven’t seen any paper or slides and thus have to rely on summaries prepared by journalists who had the pleasure to attend discussions between Alesino, Summers, Shiller, Hellwig and the likes. According to the FAZ, Alesino made the point that austerity works, in particular if politicians successfully cut expenditures and simultaneously decrease taxes in order to drastically shrink the state. This would strengthen the confidence on the side of investors and in particular of financial market actors. An increase in confidence and in political ceratinty about the appropriate economic policy then turns into investments and economic growth. Now, one could come up with the idea that Greece is a case of harsh austerity, even though it is more acase of expenditure cuts then a case where cuts of expenditures as well as tax rates were combined. Given that austerity in Greece failed, one may conclude that the failure is due to the lack of a reduction of tax rates. Not so much, according to Alesino, who would have prefered a an early default of Greece and thus a significant debt haircut. Expenditure cuts and tax rate reductions after a default and thus a serious debt reduction, however, is a case we don’t find anywhere in the Eurozone. It is a hypothetical.

In the debate about austerity a lot has been made of the size of the fiscal multiplier. Thanks to study by Oliver Blanchard and David Leigh (2013) we were hinted to insight that in a situation of an output gap the actual multiplier is much higher as has been assumed. A relatively high fiscal multiplier implies that any Euro of exependiture cuts on the side of the state translates in an over-proportional decrease of effective demand. Austerity then is like adding fuel to the fire. Blanchard and Leigh didn’t go so far; rather they proposed the need for more studies. Moreover, they made clear thatb their results are not to be read as per se against austerity teh about the timing of austerity. In contrast to Alesino they argue in favor of a backloading of austerity. A more recent study by three ECB economists (Warmedinger/Checherita-Westphal/Hernandes de Cos 2015) concludes that the effects of fiscal consolidation (austerity) differs from economy to econom,y, and this is due to country-specific multipliers. Their review of cases concludes that even high fiscal multipliers that lead to an unintended increase of the public debt ratio will medium-term end with positive results as economies move eventually on a sustainable path. In their view some economies may have no other choice then to frontload austerity as markets may interpret any other action as a intended delay of corrections, and punish those economies withn even higher risk premiums. Given the modeling restrictions the authors mention (partial equilibrium model, exclusion of critical macroeconomic features of national cases, to name two) the political conclusions in favor of front-loaded austerity seems to be rather far-stretched.

My scepticism is supported by a study of McMenamin/Breen/Munoz-Portillo (2015) who offer a first of its kind event study of public budgets. The study covers Portugal, Italy, Ireland, Greece, and Spain for the period of the late 1980s until 2012. The outcome is rather frappant: Financial markets are not very much impressed by austerity, and this holds also for the recent crisis period that started in 2010. Financial market actors do not show a strong belief in the underlying theories of austerity, and thus the credibility effect of front- loaded austerity is in some national cases negative, and overall rather weak. This result is not so surprising if we accept that financial markets are narrative-driven markets that are not so much based on particulate economic paradigms but in comprehensive reasoning that tries to cover as many variables as possible.

The debate about austerity is relevant, and yet it seems clear that it will only martginally impact the actual policy decision. In regards to Greece, the Institutions are trapped on a policy path they established early on, and unlocking is a politically sensitive as well as expensive manoeuvre. In a situation of a relatively large output gap in combination with a lower zero bound interest rate it is the job of fiscal policy to pull the wagon. This insight may be difficult to operate for an debt-plagued economy but it is not impossible, in particular if financial markets expect positive effects of growth-stimulating policies. Parts of the current debate about austerity reflects the attempt of critical actors to propagate a narrative that turns austerity into TINA. There are good reasons to counter this story.