Suppose DeLong and Summers (full paper here) are right, and at the zero lower bound temporary fiscal stimulus leads to an eventual reduction in the debt to GDP ratio because of hysteresis. Does that mean that all this austerity in the Eurozone is counterproductive? This is the question raised by John McHale. Here is an attempt at an answer, followed by some more general remarks on European austerity.
In the stylised picture above, the black line represents the debt to GDP ratio under ‘austerity’. The budget deficit is being reduced rapidly, first to stabilise the debt to GDP ratio, and then to bring it down to safer (more optimal?) levels. ‘Stimulus’ involves in the short term cutting government spending less (at least). Unless multipliers are implausibly large this will raise both deficits and the debt to GDP ratio in the short run (the red line). What DeLong and Summers argue is that the negative effects of austerity on output in the medium term will mean that the two paths for debt to GDP will at some point cross. In other words stimulus will at some point lead to a better outcome for the debt to GDP ratio.
For any government not having to pay a large risk premium on their debt, and not likely to encounter such a premium, this is an important argument. If true, it does indeed suggest that the rapid austerity being undertaken by countries such as the UK will eventually make their fiscal position worse. In addition, arguments that we have to follow the austerity path because the stimulus path is not credible are beside the point, as I argue here (and see also Summers here). Nor does the argument that we cannot change course now make much sense. In the UK and US fiscal policy does not have to be credible, it just needs to be sensible.
In the case of Ireland and other Eurozone countries the immediate motivation for austerity is a high risk premium on government debt. What potential investors in Irish government debt are worried about is not where debt is likely to end up, but the likelihood of default before we get there. Here the credibility argument does apply.
One reason why government might default is a political inability to cut spending or raise taxes enough to get the primary budget balance into surplus. Governments can demonstrate that they do have that ability by cutting the deficit rapidly now. Promises to cut it in the future carry much less weight, and so as a result have less impact on the chance of default. Even when the primary balance is in surplus, a government may decide it is in the country’s best interest to default, because any damage to its reputation will be offset by the advantages of not having to cut spending or raise taxes still further to pay the interest on its debt. Once again, a government can demonstrate that it is not minded to do this by reducing its debt as quickly as possible.
In either case, default is less likely if debt follows the black line (austerity) rather than the red line (stimulus). The markets are, quite rightly, not very interested in what happens into the medium term, because by that time default risk under either policy has all but disappeared. So if the overwhelming priority is to reduce the risk premium on government debt, austerity makes sense. In addition, as I have said often before, a long period of economic stagnation is required in many Eurozone countries to reverse the competitive disadvantage they accumulated relative to Germany in the early years of this century.
Which brings us to Germany. In the past I and others have written as if this Hobson’s choice faced by periphery Eurozone countries could be partially relieved if only Germany would expand more rapidly. However, as I outlined here, this was not a very realistic wish. Not because Germany is addicted to current account surpluses –Kantoos rightly argues that this idea is not exactly part of the German macroeconomic objective function. The reason we will not see rapid expansion in Germany is because the economy is doing all right as it is. While inflation of 5% in Germany would certainly be very useful for Spain et al, it would not be in the national German interest. The only possible exception might be if the Eurozone as a whole looked like coming apart, in which case it might be in Germany’s interests to incur these costs.
Kantoos’s final question in his post is: ‘So what else should Germany do?’ Germany should be reasonably relaxed about getting its own debt to GDP ratio down. What I have called ‘competitive austerity’ in Europe is not helpful. But being more relaxed on debt is not going to make a big difference to the rest of the Eurozone. So the realistic answer to that question is probably ‘not much’.
Seeing the Eurozone as a single bloc, it makes sense to note that fiscal correction in this bloc is far more rapid than in the US or even the UK, and for the area as a whole that will be very damaging. If there was a Eurozone government, it should be undertaking a substantial fiscal stimulus in Germany right now. But to blame Germany for not doing this of their own accord is rather pointless, as Kantoos says in a more recent post.
So the only real hope is monetary policy. I’m glad to see that Scott Sumner has decided to bury the hatchet, so let me say some more things that I think he will like to hear. While the arguments for price level or nominal GDP targets are pretty universal, I think they apply particularly to the Eurozone. The discussion above suggests that the barriers to fiscal stimulus in the Eurozone are not political but intrinsic to the union in its current conjuncture, so there appears to be no alternative to monetary stimulus. A change from inflation targeting may also be politically easier for the ECB, because it could be justified as a move back towards the ‘twin pillars’ approach and the Bundesbank’s money supply targeting. Perhaps with a new head the institution can make up for recent mistakes. A major obstacle may be that such a change would not be in Germany’s short term interests (for all the reasons noted above), in which case we may find out how independent the ECB really is from Germany.
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