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Thoughts from the Frontline

Austerity Is a Consequence, Not a Punishment

April 20, 2013

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.

The Bang! Moment

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,…

Discuss This


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Michael Bell

April 20, 2013, 5:50 a.m.

Nice, but what if Reinhart abd Rogoff are wrong? Have they been debunked?

Paul Norris

April 20, 2013, 4:49 a.m.

Nice article on the wisdom of austerity.  You accurately point how we as a nation squandered the surplus and missed our last best chance to pay off the national debt.  I find it interesting (and somewhat damaging to your credibility) that in your laundry list of mistakes made by the Bush/Hastert regime that you left out the biggest, most expensive mistake of all: passing the Bush tax cuts.  That omission makes one wonder if when you call for austerity you really mean austerity for everyone else?

Tom Warner

April 20, 2013, 4:38 a.m.

Thanks for this. I’m afraid the political winds are more behind Aga’s line of thinking than they are behind yours and mine, but so it goes. If even Italians can imagine they can somehow avoid austerity, there’s not much hope of here. The momentum for fiscal consolidation is fizzling out. After the recent payroll tax increase, tax increase on the wealthy and the sequester, I don’t expect to see any more for some time. The debt won’t be growing all that quickly for the next couple years, but whenever we have our next recession, debt will suddenly escalate.

I too think “This Time is Different” is a great book, and what people are missing is that even R&R’s critics confirmed that higher debt is associated with slower long-term growth. Of course there are huge differences from one country to another. Countries with less or worse track records pay higher interest rates, and when they try to monetize their debts, no one wants to hold the newly printed money and it goes straight into inflation and devaluation. Blaming Italy’s tight spot on its being in an “EU straitjacket” looks a bit silly when you look back on Italy’s pre-EU history. Or they try to save interest by borrowing in foreign currencies and often end up forced into default. The US is in a very favored position, as we have an excellent track record and we’re the world’s economic and military superpower. People and institutions around the world are willing to hold dollars and Treasurys in even greater quantities than the Fed and government are currently issuing. There’s no actual financial pressure on us to undertake austerity. It’s all about whether we’re forward-looking enough to maintain our track record of sound fiscal management.


April 20, 2013, 4:20 a.m.

John, I’m astounded that you would refer to the US as paying down our Federal debt in the 1990s.  The national debt grew every year through the 1990s.  There was no surplus despite what the lying media spouts.  Check the official numbers.  Federal debt was higher at the end of every fiscal year that at the beginning.

Stew Walton

April 20, 2013, 3:46 a.m.

John, I read with great interest (despite being in over my head at your economic level) and find a comparison in your “Bang” theory to a gamblers view of “betting the streak”.  They seem to possess similar views.
Thanks for the insight and explanations as I enjoy your letters.

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