Editor’s note (5/13/13): this member post is now outside the paywall to agree with this post by Roger Altman at the FT indicating that markets and not politicians are forcing the euro zone to either backstop sovereigns or face default. In the absence of the ECB going all in – which they cannot do by law, austerity is assured.
I have been sidetracked recently, but I am still in the process of finishing my European overview that I began two weeks ago. One important event which has occurred since I started writing it is the debunking of Reinhart and Rogoff. Credit Writedowns carried two posts on this last week, one from me and one from Andrea Terzi. But I would like to follow up in this daily commentary with some thoughts on Europe and Reinhart-Rogoff because I believe austerity in Europe will continue irrespective of what kind of academic research exists to justify it.
The flaws found in the Reinhart-Rogoff paper do call the premise of the paper into question. Specifically, once the missing data are added back to the data set, even using the data weighting method thatCarmen Reinhart and Ken Rogoff used, there is no ‘kink’ at the 90% government debt to GDP level. What this means in the first instance is that there is no one magic number at which government debt becomes problematic. One cannot say that this country or that country needs to engage in austerity to reduce its government debt because it has passed the magic threshold where this matters. That’s number one.
Second, irrespective of the kink, one could make the claim that the Reinhart-Rogoff analysis shows that higher government debt does impede economic growth and that this in and of itself is a reason to undergo austerity regardless of the level of government debt to GDP. Reinhart and Rogoff never spoke directly about causation in their paper. However, they have often insinuated that high government debt to GDP does cause slow economic growth, which is the main point underpinning the use of Reinhart-Rogoff to bolster the case for austerity. So, for the Reinhart-Rogoff paper to have any meaning, you need to show that high government debt causes slow economic growth, not just that the two have typically been correlated. And Reinhart and Rogoff simply have not done this.
Moreover, empirical evidence from the European crisis, where austerity has been employed in greatest measure, suggests that the causation would be the opposite, meaning slow growth or economic contraction causes government debt to rise. In every single country that has undergone austerity, growth has collapsed, the economy has slipped into recession, and government tax receipts have imploded while outlays due to automatic stabilizers have increased. Moreover, when these countries have redoubled their efforts to cut spending or raise taxes, the economy has slipped even further into recession as the lack of government spending has hurt incomes, which has lowered demand. Tax receipts have fallen even further in these cases.
The bottom line here is that the principal real economy effect of austerity has been to reduce government spending, which reduces private sector income. The private sector has reacted by trying to maintain their savings level in the face of fixed costs and high debt levels. And this has meant that the public sector cuts have caused private sector cuts as the private attempts to maintain a desired net savings level. The result is a double cut from both public and private sectors and a worsening economy, worsening tax receipts, and in some cases higher deficits.
Now, anyone who uses the sectoral balances framework to model the economy will understand this. Jan Hatzius at Goldman Sachs has been a forerunner on Wall Street in incorporating this framework into his analyses. But, this logic escapes many in policy positions and is not commonly used in the economics profession as a whole. Instead, economists talk about fiscal multipliers i.e. the degree to which a cut in government spending or an increase in taxes will reduce aggregate demand. And note that this framing of the situation assumes that the loss of government demand can be made up somewhere else in the private or foreign sectors without any thought as to how the government cuts will impact private sector income. It should be clear to anyone thinking this through that an economic agent with fixed costs and budgetary goals will need to reduce their spending if their income falls. And so a government spending cut or a tax increase has the effect of inducing a double cut from both public and private sectors, making the fiscal multiplier greater than one.
No matter. This is not important policy-wise. What is important is the prevailing paradigm and the political space policy makers have to tweak their policy agendas. As I noted when discussing political economy in the past, previous policy greatly anchors the debate. There is only so far that policy prescriptions can move given previous agendas. Right now, we are in the process of moving away from front-loaded austerity to back-loaded austerity. We see this in the timetable slippage in France, Netherlands and Spain in particular. These are large economies. And from a practical standpoint, when the whole of Europe is in recession, it makes no sense to exacerbate this by forcing these large economies deeper into recession because it will have a pronounced ripple effect. Moreover, politicians cannot get re-elected by imposing front-loaded austerity that cripples the economy. That is why fiscal consolidation timetables are slipping.
Note, however, that the rhetoric is exactly the same. We have been confronted with the fact that austerity has not worked empirically and that its theoretical underpinnings have been discredited. Yet, the belief in the policy course remains strong. For example, witness the following Op-Ed in the Financial Times by Anders Aslund of Sweden entitled Reinhart-Rogoff austerity case still stands:
The dispute has not… affected the core of Profs Rogoff and Reinhart’s work about the dangers of high public debt in states recovering from a financial crisis. They warned: “The surge in government debt following a crisis is an important factor to weigh when considering how far governments should be willing to go to offset the adverse consequences of the crisis on economic activity.”
In plain English: you should be mindful of your budget deficit, even during times of economic weakness, if you may end up with an excessive public debt. As events in fiscally conservative Ireland and Spain have shown, this is not an idle concern.
The controversy does not much affect important parts of Profs Reinhart and Rogoff’s work, such as their research on the previously understated risk of default for heavily indebted nations – something that has befallen a large number of countries in the past few hundred years. It focuses narrowly on one issue: how does a heavy debt burden affect growth?
[…]
So the Amherst researchers should be credited for having checked the details. There is plausibility to their claim that the rate at which growth declines as debt rises is linear. But take a step back. They did not seem to realise the essence of their research. They, too, found that growth falls off as public debt rises. If anything, their research reinforces the essence of the Reinhart-Rogoff thesis.
Got it? The debunking of Reinhart-Rogoff, if anything, reinforces the Reinhart-Rogoff thesis. By the way, this kind of argument derives from what in psychology is known as the backfire effect. When one’s deepest convictions are challenged, one’s beliefs actually get stronger. I wrote about this two years ago. And I am pleased to see that this counterintuitive psychological phenomenon is still valid. So, irrespective of the political expediency of backing austerity just to maintain some modicum of policy coherence, there is the very real psychological impact of being confronted with contradictory evidence this way. And as much as you would like to believe rational people would take in the information objectively, they do not. In fact, the more one knows about a subject, the more likely the backfire effect is.
And note, European policy makers are also out in full force, defending their performance.
The reality of course, is that euro zone governments do have to worry about losing market favour. They cannot rely on the central bank as a debt buyer of last resort the way the Japanese, the British or the Americans can. If, for whatever reason, sovereign debt buyers become skittish about euro zone sovereign obligations, the impact is immediate and yields rise. In a worst case scenario, you get a crisis and default as we did in Greece. So the impetus to keep sovereign debt levels manageable is clear. This makes the euro zone different from other currency areas that have currency sovereignty and flexible nonconvertible currencies.
Therefore, the conclusion here has to be that Europe will continue to underperform economically for the foreseeable future. Despite the relative value of European equities, this underperformance will put a cap on their appreciation potential.
And European sovereign bonds will also suffer as debt levels rise with austerity. Only in the corporate bond market is there space for improvement. Where the most cause for concern should be is In the European banking sector in particular. With the policy agenda moving increasingly toward bail-ins, the banking sector looks vulnerable in a world of no growth and continued austerity.
Why austerity in Europe will continue
Editor’s note (5/13/13): this member post is now outside the paywall to agree with this post by Roger Altman at the FT indicating that markets and not politicians are forcing the euro zone to either backstop sovereigns or face default. In the absence of the ECB going all in – which they cannot do by law, austerity is assured.
I have been sidetracked recently, but I am still in the process of finishing my European overview that I began two weeks ago. One important event which has occurred since I started writing it is the debunking of Reinhart and Rogoff. Credit Writedowns carried two posts on this last week, one from me and one from Andrea Terzi. But I would like to follow up in this daily commentary with some thoughts on Europe and Reinhart-Rogoff because I believe austerity in Europe will continue irrespective of what kind of academic research exists to justify it.
The flaws found in the Reinhart-Rogoff paper do call the premise of the paper into question. Specifically, once the missing data are added back to the data set, even using the data weighting method thatCarmen Reinhart and Ken Rogoff used, there is no ‘kink’ at the 90% government debt to GDP level. What this means in the first instance is that there is no one magic number at which government debt becomes problematic. One cannot say that this country or that country needs to engage in austerity to reduce its government debt because it has passed the magic threshold where this matters. That’s number one.
Second, irrespective of the kink, one could make the claim that the Reinhart-Rogoff analysis shows that higher government debt does impede economic growth and that this in and of itself is a reason to undergo austerity regardless of the level of government debt to GDP. Reinhart and Rogoff never spoke directly about causation in their paper. However, they have often insinuated that high government debt to GDP does cause slow economic growth, which is the main point underpinning the use of Reinhart-Rogoff to bolster the case for austerity. So, for the Reinhart-Rogoff paper to have any meaning, you need to show that high government debt causes slow economic growth, not just that the two have typically been correlated. And Reinhart and Rogoff simply have not done this.
Moreover, empirical evidence from the European crisis, where austerity has been employed in greatest measure, suggests that the causation would be the opposite, meaning slow growth or economic contraction causes government debt to rise. In every single country that has undergone austerity, growth has collapsed, the economy has slipped into recession, and government tax receipts have imploded while outlays due to automatic stabilizers have increased. Moreover, when these countries have redoubled their efforts to cut spending or raise taxes, the economy has slipped even further into recession as the lack of government spending has hurt incomes, which has lowered demand. Tax receipts have fallen even further in these cases.
The bottom line here is that the principal real economy effect of austerity has been to reduce government spending, which reduces private sector income. The private sector has reacted by trying to maintain their savings level in the face of fixed costs and high debt levels. And this has meant that the public sector cuts have caused private sector cuts as the private attempts to maintain a desired net savings level. The result is a double cut from both public and private sectors and a worsening economy, worsening tax receipts, and in some cases higher deficits.
Now, anyone who uses the sectoral balances framework to model the economy will understand this. Jan Hatzius at Goldman Sachs has been a forerunner on Wall Street in incorporating this framework into his analyses. But, this logic escapes many in policy positions and is not commonly used in the economics profession as a whole. Instead, economists talk about fiscal multipliers i.e. the degree to which a cut in government spending or an increase in taxes will reduce aggregate demand. And note that this framing of the situation assumes that the loss of government demand can be made up somewhere else in the private or foreign sectors without any thought as to how the government cuts will impact private sector income. It should be clear to anyone thinking this through that an economic agent with fixed costs and budgetary goals will need to reduce their spending if their income falls. And so a government spending cut or a tax increase has the effect of inducing a double cut from both public and private sectors, making the fiscal multiplier greater than one.
No matter. This is not important policy-wise. What is important is the prevailing paradigm and the political space policy makers have to tweak their policy agendas. As I noted when discussing political economy in the past, previous policy greatly anchors the debate. There is only so far that policy prescriptions can move given previous agendas. Right now, we are in the process of moving away from front-loaded austerity to back-loaded austerity. We see this in the timetable slippage in France, Netherlands and Spain in particular. These are large economies. And from a practical standpoint, when the whole of Europe is in recession, it makes no sense to exacerbate this by forcing these large economies deeper into recession because it will have a pronounced ripple effect. Moreover, politicians cannot get re-elected by imposing front-loaded austerity that cripples the economy. That is why fiscal consolidation timetables are slipping.
Note, however, that the rhetoric is exactly the same. We have been confronted with the fact that austerity has not worked empirically and that its theoretical underpinnings have been discredited. Yet, the belief in the policy course remains strong. For example, witness the following Op-Ed in the Financial Times by Anders Aslund of Sweden entitled Reinhart-Rogoff austerity case still stands:
Got it? The debunking of Reinhart-Rogoff, if anything, reinforces the Reinhart-Rogoff thesis. By the way, this kind of argument derives from what in psychology is known as the backfire effect. When one’s deepest convictions are challenged, one’s beliefs actually get stronger. I wrote about this two years ago. And I am pleased to see that this counterintuitive psychological phenomenon is still valid. So, irrespective of the political expediency of backing austerity just to maintain some modicum of policy coherence, there is the very real psychological impact of being confronted with contradictory evidence this way. And as much as you would like to believe rational people would take in the information objectively, they do not. In fact, the more one knows about a subject, the more likely the backfire effect is.
And note, European policy makers are also out in full force, defending their performance.
The reality of course, is that euro zone governments do have to worry about losing market favour. They cannot rely on the central bank as a debt buyer of last resort the way the Japanese, the British or the Americans can. If, for whatever reason, sovereign debt buyers become skittish about euro zone sovereign obligations, the impact is immediate and yields rise. In a worst case scenario, you get a crisis and default as we did in Greece. So the impetus to keep sovereign debt levels manageable is clear. This makes the euro zone different from other currency areas that have currency sovereignty and flexible nonconvertible currencies.
Therefore, the conclusion here has to be that Europe will continue to underperform economically for the foreseeable future. Despite the relative value of European equities, this underperformance will put a cap on their appreciation potential.
And European sovereign bonds will also suffer as debt levels rise with austerity. Only in the corporate bond market is there space for improvement. Where the most cause for concern should be is In the European banking sector in particular. With the policy agenda moving increasingly toward bail-ins, the banking sector looks vulnerable in a world of no growth and continued austerity.