Jun 17, 2012 at 2:14 pm
Gave a talk on austerity—fiscal contraction to offset recession–the other day at the Center for American Progress. Here’s the deck, much of which is self-explanatory, with a few annotations:
Slide 1: I actually think you’d be quite hard pressed to find an historical example where spending cuts or tax increases (especially the former) led to faster growth in the near term in advanced large economies beset by recession. There are a couple of cases where if you squint you could see it that way, but they typically involve a big cut in interest rates or a big currency devaluation.
Why do I assert that there’s simple logic here? As Jay Shambaugh points out in this excellent (and quite readable) paper, it has to do with some simple debt reduction arithmetic: d(Debt_1)=(r-g)*Debt_0+primdef.
[‘d’=”change in,” so d(Debt_1) is the diff between this year’s and last year’s debt/GDP, i.e., this year’s deficit/GDP, r=nominal interest, g=nominal growth, D_0=last year’s debt/GDP, primdef is primary deficit or deficit net of interest payments as share of GDP]
That is, a country’s debt this year equals last year’s debt plus any interest beyond growth, plus spending in excess of interest. This simple formula makes it pretty clear why a) austerity doesn’t work in slow growth, highly indebted countries—r tends to grow while g tends to shrink, and b) why it’s tempting to impose of countries like Greece, where you try to target primdef.
But, as Shambaugh points out:
If the interest rate paid on the outstanding debt is greater than the growth rate of the economy, even if the primary (not including interest) portion of the budget is in balance, debt as a share of GDP will grow. Importantly, the converse holds. Even a country with a primary budget deficit of 2% of GDP could have a shrinking debt to GDP ratio if the growth rate of the economy exceeds the interest rate by a sufficient amount.
The former case describes the troubled countries of Europe’s periphery. Take Spain (please!): g is around 0 (real GDP is falling), r’s around 7% (10-yr bond), Debt/GDP north of 80%, primary deficit around 6%. Just doing the simple math, even if you could cut spending net of interest by half—an unthinkable blow to an economy with unemployment above 20%–you’d still add to the deficit based on the unforgiving math of a high r minus a low g.
Compare that with the US, which ain’t pretty but isn’t that ugly either. G (nominal growth) is around 4% and r around 1.5%, so r-g gets you a negative, which helps reduce debt as per the above arithmetic (although our primary deficit is still highly elevated, around 7%).
All of which is to say if the capital markets view your debt as risky, leading to a high r, and you’re stuck in recession—low g—austerity is likely to hurt not only your growth prospects but your debt reduction as well. Worse, it’s a negative feedback loop. As g goes down, and r and debt go up, economies’ growth and fiscal prospects weaken further.
A few other points re the deck:
–Slide 5 is in there to remind folks that austerity is by no means just a Euro strategy. The dotted line is the fiscal cliff—this analysis is by Goldman Sachs researchers, but the CBO also found that the cliff will be recessionary, i.e., if we go over it and don’t quickly climb back.
–Slides 6 and 7 are important, to me, at least. Many economists and critics recognize the austerity problems documented thus far, but there’s been little analysis as to why so many policy makers in so many places are engaging in what amounts to medieval bloodletting. I explain the bullets in the slide in detail in a piece forthcoming shortly in Rolling Stone—I’ll link to it when it’s up.
–Slide 8 from Jay’s paper is really interesting. It’s a scatterplot of recent bond spreads against current account deficits from before the crisis. The former is a proxy for how screwed up markets judge your economy to be while the latter is a measure of how imbalanced capital flows were before the crisis. It’s an extremely tight fit and is a compelling picture
Back over to Jay:
The current account deficit represents the trade deficit, but it also represents the net borrowing by all participants in the economy from the rest of the world (if a country buys more than it sells it must borrow the money from elsewhere.) If in a crisis many private sector debts wind up becoming public debts (due to bank bailouts or other aid to the economy), one would expect that large borrowing prior to the crisis anywhere in the economy will lead to problems with sovereign repayment today because previous private borrowing may increase current fiscal risk. This, though, suggests that the problem is with total borrowing in the economy, and borrowing from outside the economy in particular, not with government borrowing per se.
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