The Corner

Making the Case for Austerity

In the current issue of Reason, I make the case for austerity. I know Krugman and DeLong are upset that many European countries won’t spend as much as they wish they would spend, but my guess is that, sitting on this side of the Atlantic, American economists are forgetting that most European Union member states have no alternative. Countries that rely heavily on foreign investors — such as Greece, France, Ireland, Italy, and Spain — must cut spending to avoid being shut off from the global capital markets:

Contrary to common belief, investors don’t judge sovereign default risks based on public debt as a percentage of gross domestic product. Instead, bond professionals grade on a curve, assessing one country’s fiscal behavior against another’s. When investors lose confidence in a government’s fiscal rectitude relative to its competitors, they withdraw, and the snubbed country suffers. Capital being a scarce good, the result is increased interest rates and a higher price for debt.

One of the key signaling devices for international investors is how a government behaves under financial duress—how it balances the demands of its debtors with those of its welfare recipients. Announcements of lower spending and higher taxes tell investors a country is willing to go to great lengths not to default on its debt obligations. If the government instead focuses on preserving its welfare state and public employee benefits, investors know default is more likely and will shy away from that country’s bonds.Japan has the world’s biggest debt as a percentage of GDP, at 227 percent, nearly four times the economist-recommended 60 percent ceiling. It has gotten away with its carelessness without risking default because the country relies more heavily than most on domestic investors to fund its follies. The United States, despite a dangerous debt burden relative to GDP (66 percent) and a structural deficit among the highest of developed countries (almost 4 percent), has so far also escaped investor censure, thanks to the perception that the dollar remains the safest currency in the world. European countries don’t have that luxury.

Alex Massie makes the same argument about Ireland:

As always, I’m not sure what Krugman’s alternative is. He’s a brilliant economist and I’m not but, in the end, Ireland’s problem has been that it ran out of money. This year Ireland is borrowing nearly €20bn to cover the gap between revenues and expenditure. That’s unsustainable and a reminder that Ireland’s woes are gravely exacerbated by but not confined to the fiasco at Anglo Irish. (And the other, smaller fiascos elsewhere in the financial sector.) No wonder the governor of the Central Bank is calling for further spendings reductions of €3bn this year.

And, again, Krugman ignores the fact that the Irish have been here before. The 1987 crisis was in some ways as bleak as Dubin’s present predicament. Perhaps an updated Tallaght Strategy won’t be enough this time, but the memory of Haughey’s reforming 1987 government remains powerful: austerity then helped create some of the conditions for future growth.

Perhaps Krugman is right that austerity is often a bad idea but it’s not been a bad idea for Ireland in the past and, anyway, given the peculiarities of Ireland’s current parlous situation it’s not clear that, for once, there was any compelling let alone palatable alternative.

This hardly means one need place any confidence in the men at the Ministry for Finance and their ability to dig the country out of the hole it’s in. But using Ireland as a pawn in some greater “Austerity Doesn’t Work” game doesn’t work either. Ireland might well be screwed regardless of what branch of painful thereapy it chose.

Here’s Megan McArdle on this same point several weeks back. If you like reading about Krugman’s errors, go here.

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