Where Austerity Really Rules

simon wren-lewisMany of us rightly complain about the damage austerity politics is doing in both the UK and the US. However, in terms of simple numbers, this is nothing compared to what is happening in the Eurozone. The table below, based on numbers from the latest OECD Economic Outlook, may look a little complicated, but it clearly establishes this point.

The first column is the general government underlying primary surplus, where underlying includes an adjustment for the cycle. (The primary surplus is basically taxes less spending, but ignoring interest on existing debt.) This is the best simple measure of fiscal impact on the economy. In the US, UK and particularly Japan, we have deficits, which are entirely appropriate in a situation of little or no recovery and with interest rates at their lower bound. Indeed I have argued that, in the US and UK, these deficits are too small given the nature of the recession: people want to save (or are unable to borrow), so the government needs to do the opposite or else output will fall.

In the Eurozone we have primary surpluses! Not just in the crisis torn periphery economies, but in the heart of the Eurozone as well. (It is for this reason that things would not be much better if the Eurozone was a fiscal union.)

These numbers on their own could be misleading: a country with a large amount of government debt will need to run a surplus in the long run to pay the interest on that debt. By comparing column 1 with column 2 we can see that surpluses in the Eurozone are high by historical standards, so the picture is the same. However this could just be because of ‘fiscal irresponsibility’ in the Eurozone in the decade before the recession. So we need to try and get a handle on sustainability.[1]

Column 4 shows debt interest payments in 2012, based on the net debt shown in column 3. You could compare column 4 with column 1, but if the two were equal and stayed that way this would mean that debt as a percentage of GDP would gradually fall over time because the value of GDP grows. [2] So, based on the implicit 2012 interest rate on debt in column 5, I’ve made up a growth corrected interest rate in column 6. (This involves subtracting a guess at an underlying growth in nominal GDP, but also increasing the interest rate, because interest rates will not stay this low forever.) The stabilising primary balance in column 7 is this rate applied to net debt, and this is compared to the actual balance in the final column.

Stabilising Underlying Government Primary Deficits (% GDP)
Source: OECD Economic Outlook December 2012

This is all very crude, but the basic message remains unchanged. Once we correct for the economic cycle, the core of the Eurozone are expected to run surpluses that are sufficient to bring down the level of debt, whereas the US, UK and Japan are planning to run deficits. In normal times, and particularly if we were in boom times, the Eurozone could rightly congratulate itself, and make disdainful remarks about policy elsewhere. During the current period in which the private sector is running an unusually high level of net saving it is completely the wrong policy. As the textbooks tell us, without the will or ability to provide offsetting monetary stimulus, this level of austerity will cause a recession, and sure enough it has.

I guess the ruling elite in the Eurozone are telling themselves that the current recession is all a result of the 2010 crisis caused by profligate governments in the periphery, and that if everyone pulls together by cutting spending and raising taxes things will come good. That has been the story for the past two years, and we are still waiting. Those who opposed this policy said that the market crisis could only be solved by ECB action, and that has turned out to be the case. We also said austerity of this kind would kill any recovery, and on that we were also right. So with macroeconomic theoryplenty of empirical evidence and recent events on our side, there is just no contest in terms of which narrative is correct.

[1] Actually, as the data shows (see, for example, Calmfors and Wren-Lewis), it was in the decades before the mid-90s that Euro area fiscal policy was irresponsible.

[2] For the debt to GDP ratio to be constant, we need the primary surplus as a share of GDP to equal debt to GDP multiplied by the nominal interest rate less the nominal growth rate.

This column was first published on Mainly Macro