A Quick Note on Austerity in the Eurozone

August 29th, 2013 at 3:32 pm

Working on a book chapter on figuring out how to turn fiscal policy right-side up again, riffing off of my CDSH hobby horse:

Me, I think the best position is to be a Cyclical Dove and a Structural Hawk (CDSH). If you’re a CDSH, your fiscal question in recessions and sloggy periods like the US (and much of Europe) are experiencing today is this: “is our budget deficit large enough to offset the demand contraction from the private sector?”

When strong private sector growth is back, the CDSH asks “now that we’re back to robust growth, are our revenues and spending lined up such that the debt we built up during the down economy will soon start to recede?” That is, deficits and debt that grow in full employment economies are called “structural” budget deficits as distinct from cyclical ones. They’re to be avoided.

In this regard, the Eurozone has ultimately reacted to the downturn as a Cyclical Hawk—i.e., in austerity mode, and that’s been a big problem.  The figure below plots real GDP growth and government spending, both indexed to ‘1’ and unemployment on the right-hand axis.


Source: Eurostat

Government spending initially stepped up to offset the sharp contraction of private sector demand, as GDP began to grow and unemployment stabilized.  Then, as various governments in the Eurozone prematurely began to consolidate their budget deficits, government spending flattened, unemployment took off again, and GDP reversed course.

Obviously, data like these collapse a lot of moving parts into one trend line, and different countries face different pressures.  There are cases in southern Eurozone countries where the loss of fiscal credibility is quite clearly linked to very high borrowing costs.  Regarding Italy, for example, Corsetti notes: “The current fiscal tightening is arguably contractionary, but the alternative of not reacting to the credibility loss would have produced much worse consequences.”

Still, that doesn’t explain the adoption of deficit reduction in the UK, nor, for that matter, the US.  And while in this country we’re on track to stabilize the debt-to-GDP ratio, at least until the pressure of health costs leads the ratio to start growing again, there are Eurozone countries for whom austerity has been self-defeating even from a fiscal perspective.  Greece, Italy, and Spain, for example, remain stuck in the vise of some highly unforgiving arithmetic, where the interest rate on their debt is higher than their GDPs nominal growth rate.  That’s a recipe for more public debt, even higher interest rates, and so on.

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One comment in reply to "A Quick Note on Austerity in the Eurozone"

  1. Auburn Parks says:

    Come on Jared, you deficit doves do more harm than good by basically agreeing with conservatives that the US budget operates the same way as a household budget. THEY ARE NOT THE SAME!!!

    Even in a growing economy, the Govt must provide Net Financial Assets in numbers greater than the trade deficit in order to maintain a positive private sector budget balance. This is simply a law of accounting, National Sectoral Balances to be exact.


    And furthermore, as you well know Jared, T-bonds are financial assets held by the private sector, so when all you mainstreamers talk about the danger of US “public debt” (a totally misleading term), you are really saying that the private sector has too many safe financial assets ad so we should reduce their wealth. Don’t you ever question your assumptions that this is so obviously a good thing. You pretend that T-bonds are like a personal mortgage where you need to have collateral. Congress created the laws that created the US dollar, its an invention. We can’t ever run out of fiat. You’re better than this Jared.

    Although admittedly, if you weren’t a reliable mainstreamer you probably wouldn’t get all those sweet TV gigs. As the old saying goes, “You can’t get a man to understand something when his salary depends on him not understanding it!”