At the Toronto summit of the Group of 20 leading economies in June 2010, high-income countries turned to fiscal austerity. The emerging sovereign debt crises in Greece, Ireland and Portugal were one of the reasons for this. Policy makers were terrified by the risk that their countries would turn into Greece. The G20 communique was specific: "Advanced economies have committed to fiscal plans that will at least halve deficits by 2013 and stabilise or reduce government debt-to-GDP ratios by 2016.” Was this both necessary and wise? No.
The eurozone was at the centre of the sovereign debt crisis frightening the world. Rapid fiscal tightening was judged essential for troubled governments. That view, in turn, persuaded those not yet subject to market pressure to tighten pre-emptively. That was very much the position of the UK’s coalition government. The idea that being Greece was around the corner gained traction in the US, too, notably among Republicans. Today’s battle over sequestration is partly a product of that concern.
A leading and, in my view, persuasive proponent of a contrary view is the Belgian economist, Paul de Grauwe, now at the LSE. He has argued that eurozone countries’ debt crises resulted from European Central Bank policy failures. Because of its refusal to act as lender of last resort to governments, they suffered liquidity risk – borrowing costs rose because buyers of bonds lacked confidence they would be able to resell easily at all times. That, not insolvency, was the immediate peril.
Today, argues Professor de Grauwe in a co-authored paper, the decision in principle of the ECB to buy up the debt of governments in trouble, through the so-called "outright monetary transactions", allows one to test his hypothesis. He notes that the chief determinant of the reduction in spreads over German Bunds since the second quarter of 2012, when OMT was announced, was the initial spread. In brief, "the decline in the spreads was strongest in the countries where the fear factor had been the strongest”.
What role did the fundamentals play? After all, nobody doubts that some countries, notably Greece, had and have a dreadful fiscal position. One such fundamental is the change in the ratio of debt to gross domestic product. The paper makes three important observations. First, the ratio of debt to GDP increased in all countries even after the ECB announcement. Second, the change in this ratio turned out to be a poor predictor of declines in spreads. Finally, the spreads determined the austerity borne by countries. Paul Krugman of The New York Times adds an extra point: austerity was costly for the afflicted economies: the greater the tightening between 2009 and 2012, according to the International Monetary Fund, the bigger the fall in output.
By adopting OMT earlier, the ECB could have prevented the panic that drove the spreads that justified the austerity. It did not do so. Tens of millions of people are suffering unnecessary hardship. It is tragic.
Nevertheless, I can see two arguments for the ECB’s behaviour. The first is that help could only follow a demonstrated willingness to embrace austerity. Second, as the latest European Economic Advisory Group report rightly notes, the real problems have been destabilising capital flows, external imbalances and worsening competitiveness, not fiscal deficits. But one can justify fiscal austerity, brutal though it is, as the only way to force adjustments of relative costs and the needed labour market reforms. My colleague, Wolfgang Mnchau, argues that the opposite is true. But I wonder whether the eurozone will survive its cure. Countries in the core would be better off themselves if they gave the weaker more time to adjust.
Countries outside the eurozone have been in a very different position. They had no need to fear the rising spreads of eurozone members because they did not face similar liquidity problems. To a first approximation, the yield on UK or US sovereign bonds should reflect expected future short-term rates of interest, with a small risk premium, since outright default is inconceivable. The widely held view that yields could soar is a bet on a surge in inflation. While inflation has been stickier than many expected, such a surge seems unlikely. Monetarists can note that the growth of broad measures of the money supply is low. Keynesians can note the excess savings of the private sector. Neither points to rising inflationary pressure.
Thus the panic that justified the UK coalition government’s turn to a long-term program of austerity was a mistake. Had its members never heard of the paradox of thrift? If the domestic private and external sectors are retrenching, the public sector cannot expect to succeed in doing so, however hard it tries, unless it is willing to drive the economy into a far bigger slump. While short-term factors have played a real part, it is not surprising that the UK’s recovery has stalled and the deficit is so persistent. It is consequently also not surprising that downgrades are on the way, not that these tell one anything very useful in the case of an issuer with access to its own money-printing machine.
As Oxford university’s Simon Wren Lewis notes, "after the panic of 2010 was over, when it became clear that the debt crisis was really a eurozone crisis and UK long-term interest rates declined with the fortunes of the economy, we should have had a major change of policy”.
What would that change of policy consist of? The answer is simple. First, serious attention needs to be paid to why the UK non-financial corporate sector is running what seem to be structural financial surpluses, as Andrew Smithers of London-based economic advisers Smithers & Co points out. Second, the austerity on current spending needs to be made explicitly contingent on the economy: more when the economy grows faster and less when the economy grows more slowly. Third, every effort must be made to accelerate any structural reforms that might encourage higher investment by the private sector. Fourth, the banking sector must come clean on losses and accept needed recapitalisation so that it starts lending again. Finally, the government must recognise that current rates of interest provide a once in a lifetime opportunity for higher public investment.
In the long run, the fiscal deficit must close. In the short run, the UK has the chance to push growth. It should take it. So should the US.
Copyright The Financial Times 2013.