How Many More Times?

One can make the point that President Trump and his administration arrived in Washington with a tunnel vision that allowed them to drastically reduce complexity in their rhetoric and also to neglect disturbing facts. The excitement about ‘alternative facts’ and other creations is justified, but then only to some degree as this attitude is far more spread than observers seem to think. One of the most striking cases are the austerity preachers Germany’s Finance Minister Schaeuble has put in place in his ministry. When it comes to finance and the Eurozone then the Finance Ministry has become the undisputed centre of the coalition government. Austerity and orthodoxy reign, and do so in flagrant violation of facts and insights. Trained lawyer Schaeuble is not only the longest serving minister in the coalition government, he is also a very smart person who thinks long-term. The most recent indication for this unusual attitude is his plan to install a European Research Network that would bring together the European International of academic austerity preachers, under the leadership of his most beloved Ifo Institute from Munich. The idea is as simple as powerful: Installing a counterweight to potential aberrations from economic orthodoxy that would reach out to Brussels and the members states in order to provide support for the German Eurozone approach, which is austerity.

The main intellectual driver of this and other attempts is Ludger Schuknecht, at the IMF at a time when the organization was still on a brutal austerity path. Today, I guess, he would not longer be hired, given his ultra-orthodox views, and the learning processes the IMF underwent. Now, orthodoxy is not the worst of all attitudes. As a matter of fact, orthodoxy reigns the landscape, in particular in Germany where economics consists only of – orthodox economists. Things y are getting hairy, though, when orthodox economists start to re-model or to neglect evidence. The master of this profession is Schuknecht. In a heated debate with Martin Wolf from the Financial Times he stated as early as 2012:

“Indeed, it is expansionary policies and weak fiscal positions that created the current problems of high debt and low competitiveness in the crisis countries in the first place. This is why the European strategy to deal with the crisis seeks to regain confidence through a combination of fiscal consolidation and structural reforms that will improve competitiveness and growth prospects. Such reforms have invariably succeeded wherever they have been implemented.”

This statement was wrong in 2012 and it is wrong today. When it comes to assess the effects of austerity then it is all about the size of the fiscal multiplier. In standard textbook, in so far as it covers multipliers at all, the fiscal multiplier is > 1. It it usually defined as the ratio of a change in output in relation to a discretionary change in government spending or tax revenue. The idea then is that additional government spending (or a reduction of tax rates) will have first round and decreasing but positive multiple round effects that result in larger GDP-effects than the initial push. In regards to austerity, i.e. reductions of a broad range of government spendings, the size of the multiplier is critical already when it comes to designing austerity policies. Astoundingly enough the debate about fiscal multipliers was lifted on high plateau when Oliver Blanchard and Co published their piece that showed that the fiscal multiplier for a range of Eurozone economies was much higher than anticipated, and thus the negative GDP-effects actually much more substantial than policy-makers, and the IMNF, were aware of when they proposed austerity. Since, a multitude of empirical studies using a variety of approaches to measure fiscal multipliers came to converging results, namely that under conditions of lower zero bound monetary policy and debt overhangs, the fiscal multipliers are very high. Jorda and Taylor in a more recent paper in The Economic Journal (2016) used so-called propensity-score based methods for time series data, and showed show that austerity is always a drag on growth, especially in situations of under-utilized capacities. According to this study a fiscal retreat of 1% of GDP fiscal results in a loss of 3.5% of real GDP over five years when implemented in a slump,compared to a 1.8% loss under conditions of a booming economy. House, Proebsting and Tesar in a NBER paper applied amulti-country DSGE model that was calibrated top 29 advanced economies over the period 2010 to 2014, ands came to the conclusion that fiscal austerity resulted in severe negative GDP-effects, a lowering of inflation and at the same time added a strong mercantilist component to the effects as trade balances were improving across the board. Engler and Kleion analyze austerity measures in Spain, Italy, and Portugal and came to the conclusion that fiscal austerity did not only not achieve its own goal, namely a reduction of the debt ratio, but actually severed the recession in all three cases. Austerity, in other words, was crucial in deteriorating the economic situation and in generating hysteresis effects that continue to last. There are many more studies showing similar results.

Why then is Schaeuble’s team so determined to promote austerity and to whitewash a terrible policy outcome? It is fair to note that Germany lately was accepting some flexibility in interpreting the fiscal rules in the Eurozone, and did no longer insist on austerity pure. However, this should not be interpreted as giving in to critics or to move to a more responsible fiscal policy approach. Schaeuble’s policy stance has not changed since he wrote in an op-ed in the Financial Times in 2011:
“The recipe is as simple as it is hard to implement in practice: western democracies and other countries faced with high levels of debt and deficits need to cut expenditures, increase revenues and remove the structural hindrances in their economies, however politically painful. Some progress has already been achieved in this respect, but more needs to be done. Only this course of action can lead to sustainable growth as opposed to short-term volatile bursts or long-term economic decline. There is some concern that fiscal consolidation, a smaller public sector and more flexible labour markets could undermine demand in these countries in the short term. I am not convinced that this is a foregone conclusion, but even if it were, there is a trade-off between short-term pain and long-term gain. An increase in consumer and investor confidence and a shortening of unemployment lines will in the medium term cancel out any short-term dip in consumption.”

Seven years later it becomes clear that the long-term gains are actually losses as the majority of the hardest huts economies still have not been successful to compensate for the GDP losses they experienced. And yet, it is also clear that there is light at the end of the tunnel. This light, one can argue, has not much to do with austerity but a lot with the eventually aggressive bond purchase program of the ECB that slowly but steadily lifted the inflation rate and may (!) lift the Eurozone out of its deflationary phase. It may be well the case that Schaeuble and his team publicly discount the ECB action and explain the slow recovery with – austerity. Not to talk about the mercantilist implication of harsh austerity that led to a significant depreciation of the exchange of the Euro, and helped jointly with the depressed import demand to provide the Eurozone with a read balance surplus. In other words, the slow recovery is to some degree also the result of a currency effect – latter may not have been intended but then it does not do any harm to the Eurozone.

Austerity policies in the Eurozone definitely did not damage Germany. The Eurozone-internal capital flight to Germany filled the coffers of the Finance Minister, and it was also helpful that Germany’s bunds turned as cheap as never before. Schaeuble’s ‘Black Zero’ could be accomplished without putting pain on German voters – no small feast. The depreciation of the Euro pushed German exports from record to record, and even though it is violating with its current account surplus the Macroeconomic Imbalance criteria, there aws never the fear to get punished for it. The idea that a surplus could be a bad thing seems to be a crazy idea for German mainstream economists, and more so for politicians. All in all good reasons for Schaeuble and his team comprise the virtues of austerity, many more times!