American Austerity

Today's New York Times article on the Irish economy makes for depressing reading.  Despite swift moves for wage cuts and other austerity measures (backed by the unions, no less), the deficit is almost 15% of GDP, and the spread between Irish and German debt is about 300 basis points.  Unemployment is high, and long-term unemployment makes up a significant portion of the problem.

Given all that, Kevin Drum asks

In the case of Ireland, it's not clear if they had a lot of choice. They're a eurozone country, so they couldn't devalue their currency, and they're running monster deficits even with the cutbacks they've made. Bigger deficits might simply not have been possible for a country their size.

Still, the results are pretty obviously horrific, and any country that can avoid Ireland's fate surely ought to. We certainly can, for example. So why do so many people want us to follow the Irish path instead?

Well, for starters, we don't know that the results have been pretty horrific.  What we know is that financial crises are pretty horrific, and that Ireland, for a number of reasons, was especially vulnerable to crisis.  (Small economy, no independent monetary policy, highly export dependent . . . the list goes on).

Saying that "the results have been horrific" implies that we know the alternative, in the form of even higher debt, would not have been even worse.  That is certainly the dominant macroeconomic theory, but that theory hardly rises to the second law of thermodynamics.  

I am rather reminded of Ken Rogoff's infamous Open Letter to Joseph Stiglitz, when Stiglitz wondered why everyone had all this wrongheaded insistence on austerity:

Let's look at Stiglitzian prescriptions for helping a distressed emerging market debtor, the ideas you put forth as superior to existing practice. Governments typically come to the IMF for financial assistance when they are having trouble finding buyers for their debt and when the value of their money is falling. The Stiglitzian prescription is to raise the profile of fiscal deficits, that is, to issue more debt and to print more money. You seem to believe that if a distressed government issues more currency, its citizens will suddenly think it more valuable. You seem to believe that when investors are no longer willing to hold a government's debt, all that needs to be done is to increase the supply and it will sell like hot cakes. We at the IMF--no, make that we on the Planet Earth--have considerable experience suggesting otherwise. We earthlings have found that when a country in fiscal distress tries to escape by printing more money, inflation rises, often uncontrollably. Uncontrolled inflation strangles growth, hurting the entire populace but, especially the indigent. The laws of economics may be different in your part of the gamma quadrant, but around here we find that when an almost bankrupt government fails to credibly constrain the time profile of its fiscal deficits, things generally get worse instead of better.

Joe, throughout your book, you condemn the IMF because everywhere it seems to be, countries are in trouble. Isn't this a little like observing that where there are epidemics, one tends to find more doctors?

You cloak yourself in the mantle of John Maynard Keynes, saying that the aim of your policies is to maintain full employment. We at the IMF care a lot about employment. But if a government has come to us, it is often precisely because it is in an unsustainable position, and we have to look not just at the next two weeks, but at the next two years and beyond. We certainly believe in the lessons of Keynes, but in a modern, nuanced way. For example, the post-1975 macroeconomics literature--which you say we are tone deaf to--emphasizes the importance of budget constraints across time. It does no good to pile on IMF debt as a very short-run fix if it makes the not-so-distant future drastically worse. By the way, in blatant contradiction to your assertion, IMF programs frequently allow for deficits, indeed they did so in the Asia crisis. If its initial battlefield medicine was wrong, the IMF reacted, learning from its mistakes, quickly reversing course.

No, instead of Keynes, I would cloak your theories in the mantle of Arthur Laffer and other extreme expositors of 1980s Reagan-style supply-side economics. Laffer believed that if the government would only cut tax rates, people would work harder, and total government revenues would rise. The Stiglitz-Laffer theory of crisis management holds that countries need not worry about expanding deficits, as in so doing, they will increase their debt service capacity more than proportionately. George Bush, Sr. once labeled these ideas "voodoo economics." He was right. I will concede, Joe, that real-world policy economics is complicated, and just maybe further research will prove you have a point. But what really puzzles me is how you could be so sure that you are 100 percent right, so sure that you were willing to "blow the whistle" in the middle of the crisis, sniping at the paramedics as they tended the wounded.

Rogoff is quoted in the article, but the author rather glosses his point:  If Ireland hadn't done the austerity budget, it might now be more like Greece--in danger of default without massive intervention from the rest of the European Union.  Intervention that might well not be forthcoming, if it became clear that too many countries were going to require it.

Of course, we do not yet have uncontrolled inflation (or really, any sort of inflation) in the United States.  And demand for US debt remains robust.  So why wouldn't we try more stimulus?

That's a plausible argument.  But you have to balance it against another plausible argument, which is that all the countries who are now in trouble were once countries who found themselves able to borrow at surprisingly attractive rates.  In fact, due to external market conditions, these rates were actually often somewhat lower than they were used to paying.  This did not end well.

Austerity is an expensive form of insurance against a true fiscal crisis.  And though it doesn't necessarily seem like it when you're not having one, fiscal crises are much, much worse than austerity budgets.  Fiscal crisis means that rather than unpleasant cuts, you have sudden, unmanageable collapses in things like public pension plans.  The resulting suffering is not unpleasant; it is disastrous.

A year or two ago, I'm sure some corporate executive at BP was asking why the company would consider installing expensive remote control valves on its offshore rigs, when this sort of spill is extremely rare, and the fail-safe might not even work.  One could even argue that given the economic cost of higher gasoline prices, and the rarity of these spills, BP made a good bet.  We might well . . . if the spill hadn't happened.

But once it has, we're damn sure that we wanted them to be a lot more careful, no matter what the cost.

Just as even before the spill, some environmentalists were sure they wanted the added protection at whatever cost, some fiscal hawks are sure they want the added protection from fiscal breakdown.  Given that the odds of fiscal crisis are less than 100%, this is certainly arguable.  But unless you know how much less than 100% they are, it's not exactly crazy to try to head it off by spending less than the bond markets are willing to let us.