Is Greece's Austerity Budget a Big Mistake?

This morning, Greece passed another austerity budget.  This has been, to put it mildly, unpopular.  The country has been beset by days of riots in protest of the spending cuts, apparently led by self-proclaimed anarchists who seem to be a mite confused about what the word means.

The move has also been unpopular with liberals here.  While I was on vacation, I got a note from one of my favorite email interlocutors, expressing a sentiment I've seen on Twitter this morning:

Why? Why is George Papandreou doing this? Why would a socialist push harsh austerity measures year after year, ignoring the political incentives, ignoring his own plummeting popularity, in the name of making sure that German creditors don't lose any money? I mean, I find myself turning to very simplistic psychological explanations, such as - he's doing it for the same reason that Rush Limbaugh pushes the Heritage Foundation, he's being bribed. Or he's being overwhelmed by the fancy arguments of all his rich friends and a bunch of sophisticated bullshit into acting in their own interests, instead of his country - i.e. he's timid, or he's stupid. Or there's an inferiority complex among the Greek elite, after decades of being mocked as a basket case, leading to an emotional refusal to act uncool, with uncool equaling default, even at the expense of his own citizens and his own career. It all boils down to some form of hallucination, some inability to think, some onset of stress-induced mental paralysis. A national nervous breakdown.

I wrote back then "it's a good question", but I was on vacation with limited internet access, so I promised to respond later.  And now I am.

I must start by pointing out that Greece is not somehow a proxy for what is happening here.  You can be in favor of further stimulus here, and further austerity in Greece (and indeed, many are).  At best, Greece has some limited value in illustrating what happens when you let your government finances out of control--but only limited, because they have a whole set of currency issues that America doesn't face.

Greece is currently running what's known as a "primary deficit"; as far as I can tell, it's about 5% of GDP.  The primary budget balance (surplus or deficit) is the state of the budget if you take out interest payments.  You can be running a primary surplus but still have a substantial budget deficit if your interest payments from past deficits are heavy enough, and in that situation, there's an easy argument that defaulting will make your population better off.  That argument may not be correct, especially over the long term--Argentina's lack of access to external finance has caused the government to resort to ever-dodgier tricks such as seizing private pension funds.  But it's at least clear that defaulting fixes your short-term problem.

That's not the situation that Greece is in.  Even if it makes no interest payments at all, Greece needs to borrow money in order to keep funding all the spending it's committed to.  And it can't really finance that domestically, since for various reasons, a Greek government default would render most of its banking system at least temporarily insolvent.  Papandreou is passing these cuts because these cuts are what is necessary to get external institutions, like the EU and the IMF, to keep funding his primary deficit.  If he refused, the financing would dry up, and Greece would be forced to make even deeper cuts.  They would also have to try to raise more revenue with higher taxes, but this is very difficult in Greece, where compliance is low and the officials in charge of collecting your taxes are generally quite corrupt.

Now, you could say that this just pushes the problem up one level: why are external institutions demanding this austerity?  One answer is simply political.  The Greek population got themselves into this by demanding that the government spend wildly more than they were willing to fund with their taxes; when the euro took away the government's ability to inflate away the value of the resulting debt, the previous government resorted to accounting fraud.  The German people are not going to pay for the Greeks to continue this behavior--not when the German people have been busily living within their means.

But there is also a principle behind it, discussed by Ken Rogoff in his justly famous open letter to Joe Stiglitz on this topic after Stiglitz wrote a rather blistering book attacking the IMF.  I quote liberally:

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.

Does that mean that Greece, or the EU, is doing the right thing?  Not necessarily.  My own belief is that Greece should exit the euro, and redenominate its debt in drachmae, which would constitute a de-facto default; perhaps it should also lengthen terms, cut interest rates, or otherwise force investors to take a haircut.  The current debt load is obviously unsustainable, and what's more I do not see any way to make it sustainable, because the current austerity is politically unsustainable.  Greece might as well bear the pain now as later.  Exiting the euro would give their economy its best shot at growing again.

Moreover, Wolfgang Munchau makes a pretty strong argument that this austerity plan isn't even going to get the Europeans what they want, which is to hold the euro together:

There is no doubt that Greece needed a large fiscal adjustment. And, yes, the Greek government backtracked a little on the previously agreed programme to win support for last week's vote of confidence. The latest slice of austerity was intended to plug this gap. But it would be a mistake to deprive Greece of all means of political manoeuvre.

Politically, the new austerity programme is backfiring already. It strengthens the position of Antonis Samaras, the Greek opposition leader, who opposes it. Fellow centre-right EU leaders last week put pressure on him. He resisted. His argument is that austerity is killing the economy and that Greece now needs a jolt to get it back to a growth path.

By unwittingly strengthening Mr Samaras's resolve and his public support, the EU destroys any chances of the national unity it so desperately seeks. This is, after all, going to be a programme lasting several years. If the present government were to fall, Mr Samaras would stand a good chance of winning. He is already ahead in the polls. If elected, he would ask the EU to renegotiate. The EU and the IMF might decline. The whole strategy could unravel at that point.

But it's not hard to understand why the EU is doing what it's doing.  Their voters are ordinary people pissed off about their tax dollars going to finance Greek profligacy, and it's not unreasonable to worry about moral hazard if peripheral euro members get the idea that the rest of the euro zone is going to write checks to finance any size budget deficit they'd care to run.  Nor is it difficult to understand Papandreou's actions: leaving the euro is a major decision. Until the current mess, the Greek government was a big beneficiary of membership, enjoying unnaturally low rates on the massive amount of money it borrowed and spent.  And leaving will trigger all sorts of unpleasant events, like capital flight and an international political crisis with their major trading partners.  As long as the other Europeans are helping them run a deficit, they're likely to keep going along.

And if they do leave, and/or default, they will not instantly enter some Stiglitzian paradise where benefits are paid and the economy seamlessly shifts into faster growth.  The initial result will be more government austerity as the external finance taps are shut off, and a big drop in GDP due to the disruption in the financial system.  There will also be considerable disruption in peoples' lives due to uncertainty about the banks, the government, and/or the currency.  This may be best for the long run, but in the short run, it's going to be incredibly miserable for both the Greek people, and the government who leads them into the situation--as their crisis came to a head, Argentina's government had four leaders in the space of a month.  Papandreou is not deluded, and he's not trying to impress his rich European friends.  He's doing his best to muddle through a very, very bad situation.