Two seemingly different questions and comments from readers and friends crossed my path the last few days, but I saw a definite connection between them. The first question was, Why do we pursue austerity when it seems not to work? And then many readers wrote to ask this week, What do I think about the real problems that are surfacing in the Rogoff and Reinhart assertion that debt above a ratio of 90% debt to GDP seems to slow economic growth by 1% (especially since I have quoted that data more than a few times)? We’ll deal with each question separately and then see if we can connect the dots.
The first question comes from correspondence I have had with Ms. Aga Barberini, who works in the investment world in Milan, Italy. She came there from Poland some 20 years ago. The first part of her note contains the question on austerity, but I’ll pass along more of her letter, as I think it will give us all some insight into the seeming chaos that voters are facing in choosing a path for Italy. (And I hope my editors leave some of the charming grammar in her letter. You can almost hear the musical tones of her Italian English.)
I am worried for Italy, too. When I came here 20 years ago Italy was beautiful and rich; it was very good for a girl from Eastern Europe. Nowadays a lot of Italians go to Poland and settle down.
I guess it’s going to get worse, the austerity will be tighter. Please tell me why should we go ahead with austerity when IMF last month came out saying that for every point of tax lifting in Italy we lose 2.5 points of GDP? First they said that the tax lifting would produce only 0.5 points of GDP slip, now they say they were wrong.
The political chaos is lasting. My husband says, why don't we vote for the comedian in June (as it is almost sure we are going to vote again soon)? Sure, Grillo is right in a lot of things and would clean the politics a lot. (By the way, did you know that the oldest bank in the world, Monte dei Paschi di Siena’s mess is reaching 20 billion euros? They took away the money doing ... the bank transfers ;-) The Banka d'Italia didn't see; CONSOB, the Italian SEC, didn't see...). But how can a serious person vote for the comedian?
But I say sometimes the one who is good for the revolution isn't necessarily good to rule the country. Do you remember the guy called Lech Walesa? Thanks to him the communism [in Poland] was fallen – we all agree. Polish people were so thankful to him that we appointed him for the first democratic president. Than we found that he didn't have enough background to rule the country and enough culture to represent us on the international stage.
I will vote Berlusconi again. I can't stand communists even if they call themselves “the left.”
(Sidebar: I was in Siena last summer and visited the ancestral home of the bank mentioned above, the world’s oldest, founded in 1472. I marveled that any bank could last so long. At the Palio last summer we met one of the senior managers of the bank. It turns out that it was local politicians who ran the board of the bank, and now the authorities are saying management hid the problems from them.)
So let me try to answer you, Aga.
Austerity has come to have a rather bad name of late. The complaint is that it just doesn’t work. Which is somewhat like complaining that the roof is leaking because someone else hassn’t fixed it. If by “working” we mean that austerity is supposed to produce growth, then of course it doesn’t work. By definition, austerity means you are reducing a fiscal deficit, and doing so will reduce growth in the short term. That begs the question, why would you want to do that? Don’t we want growth? Let’s look at why a country might need to endure austerity.
“Austerity” is now the name we give to the situation where a government has to limit its spending during an economic downturn or recession. The governments of the developed world amassed huge sovereign debts in the course of what is known as the Debt Supercycle. As interest rates fell, borrowing to finance consumption and spending became easy. But now that decades-long supercycle has ended.
One way of looking at the problem of swollen sovereign debt is to say that it goes back to Keynes (although one cannot actually blame the current problems on his economic theory). Keynes argued (roughly) that when there is a normal business-cycle recession a government should spend money to counterbalance the private-economy slowdown. That means that the government should borrow money and run fiscal deficits to help boost spending and the economy. According to his theory, this would make the recession not as deep and help bring the economy back to recovery sooner.
This was tried after World War II in numerous countries in the developed world, and it seemed to work. "We are all Keynesians now" is a famous phrase uttered by Milton Friedman and attributed to US President Richard Nixon. It is popularly associated with the reluctant embrace of Keynesian economics in a time of financial crisis, by individuals such as Nixon, who had formerly favored less interventionist policies. (The phrase was first attributed to Milton Friedman in the December 31, 1965, edition of Time magazine. In the February 4, 1966, edition, Friedman wrote a letter clarifying that his original statement was, "In one sense, we are all Keynesians now; in another, nobody is any longer a Keynesian.") (Wikipedia)
The problem that arose was that most countries rarely followed through on the second part of Keynes’s prescription, which was to pay back the debt when times were good. Rather, the debt just continued to accumulate. But, because interest rates were dropping, the size and cost of the debt became less of an issue.
And, as Rogoff and Reinhart showed through their massive data collection and work on sovereign debt crises, published in This Time Is Different and elsewhere, debt is not a problem until it becomes one. And then it reaches a critical mass and you have what they called the Bang! moment.
I want to review some of their work, which will help us understand the reasons for austerity,…