A client brought to my attention an article published in the Financial Times earlier this month, when I was out of the country. Author Wolfgang Munchau disagrees with the degree of austerity being imposed on Greece, due to the requirements of the International Monetary Fund, European Central Bank and he European Community itself. He argues that Spain is doomed to go the way of Greece, suffering a a brutal level of economic contraction as it tries to meet the mandate to achieve a primary budget surplus,
Munchau’s theme is a variation on one endlessly repeated by Paul Krugman, New York Times columnist, Princeton economist, Nobel Laureate and energetic hater of all things Republican. These critics point out that too much austerity is self-defeating. By requiring as a target a primary budget surplus, you impose such massive spending cuts and outsize tax increases that you deepen the existing recession, thus reducing revenues and putting budget balance again out of reach. So you cut spending and raise taxes even more, further slowing the economy. You end up in a kind of self-reinforcing financial death spiral. It would be better to spend now, stimulate the economy, and then cut at some future date, when worldwide economic contraction did not create such a headwind.
So which policy is wiser, one of brutal cuts now to achieve balance, regardless of economic cost, or a policy of increased spending with austerity deferred until better times?
Unfortunately for Krugman, Munchau and the other critics of austerity, in practice the question is meaningless. Neither Greek and Spanish austerity measures on the one side, nor the rescue programs administered by international institutions on the other, will be designed and implemented by dispassionate philosopher-kings, answerable to nobody but their own consciences and the Nobel Peace Prize voters. Both parties to the austerity debate are politicians answerable to unhappy voters.
What we observe in Europe’s most troubled economies is a version of the classic prisoner’s dilemma from game theory. While in theory having each side ignore its own immediate self-interest might lead to a better global outcome, in practice the incentive for the borrower to avoid reform is too large.
Elected leaders in Greece and Spain will not pay the brutal price of reforms if they can avoid or defer them. (For example, if someone offers to let them continue deficit spending to stimulate growth.) Munchau acknowledges this when he notes that Spain still maintains the fantasy that not a single institution in their entirely insolvent banking sector will be shut down.
Nor will German voters accept delay in the implementation of structural reforms by the Club Med nations (Greece, Spain, Portugal and maybe Italy.) Germany made its own reforms in the early 2000s, under Social Democrat Gerhard Schroder. German workers accepted workplace reform, delayed retirement dates, lower taxes on higher incomes, all in order to improve German industry’s competitive position in the global economy. German taxpayers who can’t retire until age 67 are not happy about sending dollars to Greek civil servants who retire at age 52. Both German voters and their elected leaders believe that reform deferred is reform denied.
This is one case, I think, where using a household analogy captures accurately the reality of an international economic issue.
Imagine your ne’er-do-well brother-in-law, who has placed his family in debt through a combination of high living and failed business ventures, wants to borrow money to make the payments on his new high-end pickup truck. You’ve loaned him money before to pay his real estate taxes, settle his gambling debts, fund a new business venture, and he has never paid back a penny. He’s lied about his finances, and he lives a higher-speed lifestyle than you do, even though his income is much lower.
But this time he is really, really broke. If you don’t pony up the cash, the bank will repossess his pickup truck and he won’t be able to do the odd jobs that provide his household’s only income.
If you have been burned many times before, you may well decide to refuse to throw good money after bad, regardless of the consequences to his standard of living or to family harmony. And that is where Spain and Greece find themselves, in a position where those keeping them afloat will accept nothing less than the most immediate and severe budgetary discipline.
The lesson here is, change before you have to, as Germany did in the early 2000s, Canada in the late 1990s and Sweden in the early 1990s. Once you place yourself in a general condition of default, dependent on international rescue to make monthly payrolls, your policy options will be both limited and sub-optimal.
As our own government debt grows beyond 100% of our GDP, this is a lesson that our politicians would be wise to heed.