An empirical nail for the austerity coffin
Fresh analysis disproving the correlation between debt levels and eurozone bond spreads puts the brakes on the allure of austerity.
That happened today as I prepared to write my "Krugman doesn’t understand IS-LM” post: I checked his latest blog entry "Paul De Grauwe and the Rehn of Terror” and found he’d linked to an excellent empirical paper on how austerity policies had functioned in Europe – or rather, how they had malfunctioned – written by Paul De Grauwe of the London School of Economics and Yuemei Ji of the University of Leuven. Since politicians everywhere seem enamoured of austerity right now, this empirical work deserves wide exposure; my theoretical pot-shot at Krugman can wait.
The crisis-du-jour that is driving politicians to impose austerity is the high and rising level of public debt: just as a household has to 'tighten its belt' if its spending exceeds its income, so politicians seem to believe must a nation. If a household does this, its balance sheet improves at the cost of a drop in living standards, because expenditure falls while its income remains constant.
But what about a country: does its income remain constant if a large component of it – the government – cuts its spending?
Before Europe’s experiment with austerity, the neoclassical economists that Krugman describes as "freshwater economists” argued "yes, it does” on the basis of what they called (I hope you’ve had your morning coffee) Reverse Ricardian Equivalence. The decline in government spending, they argued, would cause the private sector to spend more because people would realise that taxes would be lower in the future. So governments could cut their spending without having to worry about the country’s gross domestic product falling as a result.
If you followed that last link, you would have noted that the date on that article was October 2010 – over two years ago. That’s the last time the empirical data gave that particular canard any wings. Since then, the empirical data has confirmed that a nation’s GDP will fall if its government cuts its spending – and in some cases, fall so much that the public debt-to-GDP rises because of austerity, when the objective was to reduce that ratio.
De Grauwe and Ji add to this literature by showing that the finance markets comprehensively underpriced sovereign risk in Europe before the crisis, and overpriced it afterwards in a way that helped cause the drive towards austerity.
How? Here the euro plays a crucial role. Since countries in the eurozone don’t produce their own currencies, and since the Maastricht Treaty technically bans the European Central Bank from financing a government deficit of more than 3 per cent of GDP, these governments have to issue bonds denominated in euros to finance deficits greater than 3 per cent of GDP. They then have to tax their own populace to raise enough money to service these bonds, at whatever rate the market sets.
This is where the market adds to the insanity of the Maastricht Treaty itself. If the myth of efficient markets applied in reality, the bonds of countries that ran larger deficits would always have been valued below those of countries running small ones or surpluses. So a German euro 10-year bond with a face value of €1000 in ten years’ time would sell for, say, €820 today, with an effective interest rate of 2 per cent. Germany would only need to sell about 1220 of them today to raise €1 million, and it would need to repay investors only €1.22 million in ten years’ time. But a Greek bond with the same term and face value would have sold for, say €614, representing a 5 per cent interest rate and the need to repay €1,628,895 in 10 years’ time. Germany could have been fairly relaxed about its deficit, while Greece would have needed to control its spending.
But that isn’t what happened. Before the crisis, the market effectively treated the bonds of Greece as equivalent to those of Germany: there was effectively no 'market premium' for risk. Greece could service its deficit as if it were Germany. Then after the crisis, that premium exploded: the spread between Greek and German rates rose from effectively zero to over 20 per cent (see figure 1, which is from an academic paper by De Grauwe and Ji, not the accessible Vox EU article).
Figure 1: Spreads between German and other country bond rates, from De Grauwe & Ji 2012
Countries like Greece went from relaxed to stressed in a flash, and it’s little wonder its politicians thought austerity was required. This is precisely what De Grauwe and Ji found, and with a remarkable regularity: the bigger the blowout in the spread between a given euro country’s bond rates and Germany’s, the bigger the austerity drive their politicians imposed (see figure 2).
Figure 2: The correlation between spreads and the severity of austerity imposed in 2011
As De Grauwe and Ji put it: "There can be little doubt. Financial markets exerted different degrees of pressure on countries. By raising the spreads they forced some countries to engage in severe austerity programs. Other countries did not experience increases in spreads and as a result did not feel much urge to apply the austerity medicine."
But were the markets right to effectively force countries like Greece into extreme austerity – or was their judgment after the crisis as bad as their judgment before it, when they treated Greece and Germany as just two brands of vanilla ice cream?
Here De Grauwe and Ji do some lovely lateral thinking. If the market was right, and only the market mattered, then any centralised action by the ECB to try to control the crisis would have either failed, or not discriminated between countries: those with bad fundamentals (like Greece) would still have faced a premium over those with good ones (like Germany).
Well, the ECB did try to control the crisis in 2012 by effectively breaching the Maastricht Treaty’s limits on its powers and announcing that it would act as a "lender of last resort”. The impact was that the spreads between German bonds and the rest contracted dramatically – and the bigger the gap in 2011 before the announcement, the bigger the contraction.
Figure 3: Contraction in spreads after ECB announced its intention to backstop euro bonds
Could this decline have really been due to austerity working, and the 'fundamentals' – the government debt-to-GDP ratio – getting better in those countries subject to greater austerity? Nope: firstly, there was precious little relationship between the change in spreads and the change in the government debt level, and secondly, the debt level continued to increase anyway (see figure 4).
Figure 4: One outlier (Greece) drastically affects this regression, but the direction is 'wrong' in any case
Secondly, the bigger the austerity drive, the more GDP fell. But the clincher is the third point: the bigger the austerity drive, the larger the increase in the government debt-to-GDP ratio!
In other words, though the intention of austerity was to reduce the government debt-to-GDP level, the impact was to increase it: the decline in GDP was greater than the decline (if any) in the nominal deficit (see figure 5).
Figure 5: The Greek debt ratio excludes the debt restructuring of end-2011 that amounted to about 30 per cent of GDP
Austerity has thus been an abject failure, motivated by panic rather than intelligent thought, and counterproductive in its outcome. De Grauwe and Ji conclude that financial markets made a bad situation worse by excessive confidence prior to the crisis and panic afterwards, which amplified the same behaviour by policy makers:
"Since the start of the debt crisis financial markets have provided wrong signals; led by fear and panic, they pushed the spreads to artificially high levels and forced cash-strapped nations into intense austerity that produced great suffering.
"Panic and fear are not good guides for economic policies.
"Financial markets did not signal northern countries to stimulate their economies, thus introducing a deflationary bias that lead to the double-dip recession."
They also finish with a theme that has occupied me for some time: the potential for these austerity policies to lead to a grassroots revolt against the euro (which could well involve fascist parties gaining power, as they did during the Great Depression):
"As it becomes obvious that the austerity programs produce unnecessary sufferings especially for the millions of people who have been thrown into unemployment and poverty, resistance against these programs is likely to increase. A resistance that may lead millions of people to wish to be liberated from what they perceive to be shackles imposed by the euro."
Finally, if this empirical evidence still sounds just too weird to you, try this analogy: if you were driving around a bend at too high a speed and your car started to skid, what would you do?
I know what I’d do: I’d turn the wheel even more in the direction I wanted to be going, and consequently crash. That’s because though I’m a good economist, I’m just an average driver. I even think I know what the correct thing to do is – something about turning the wheel in the direction of the skid – but at an instinctive level, that seems counter-intuitive. I have never practised that trick, and if I did get into a skid, my panicked reaction to the skid would win over my unpractised knowledge.
Ditto here. It seems paradoxical to argue that countries that apparently have a deficit problem shouldn’t try to reduce their deficits directly by austerity, but that’s the rub. Just as what makes sense in normal times when driving doesn’t make sense in abnormal ones when the car’s wheels have lost traction, austerity during a crisis is the wrong way to get out of it.
That’s a nice segue into how Krugman is using IS-LM (and why he’s wrong), so I’ll leave De Drauwe & Ji there, and return to IS-LM next week. In the meantime, do read their paper, and spread the word: we need intelligence rather than panic now, and I second Krugman on recommending their clear and compelling empirical analysis.
Steve Keen is professor of economics & finance at the University of Western Sydney and author of Debunking Economics and the blog Debtwatch. His Minsky Kickstarter page is here.
De Grauwe and Ji’s work is publicly available on the Vox website – see "Panic-driven austerity in the Eurozone and its implications” – and is based on a 2012 academic paper "Mispricing of Sovereign Risk and Macroeconomic Stability in the Eurozone” that lies behind Wiley’s academic paywall.