Is the academic premise for austerity in the eurozone crumbling? Not quite…

A mini-storm has been whipped up in the economic community overnight after a paper was published highlighting some flaws in the widely cited Reinhart & Rogoff paper ‘Growth in a time of debt’.

A quick recap for those of you not familiar with the paper. It essentially argues that high debt levels are associated with low economic growth. It bases its analysis on data from 44 countries over the past 200 years. It also notes that this relationship gets stronger once debt exceeds 90% of GDP. The paper has been widely cited in defence of and in support for ‘austerity’ – by politicians in both the US and Europe (notably Olli Rehn in respect to the eurozone crisis).

The new research released challenged Reinhart & Rogoff’s (R&R) findings, on the basis of an excel error (oops), data omissions and incorrectly weighting of data. There has been plenty written about which side is correct – you can see a summary of criticisms here and R&R’s responses here and here.

The question that interests us is not necessarily the intricacies of this academic back and forth. To be honest, it is obvious that there is no clear single threshold above which debt begins to impact growth in all countries and that often specific historical experiences in certain countries may not mean much for policies in different times and places (see this Ed Hugh post for a good summary). This is particularly true given some of the unique constraints of the eurozone crisis.

But given that some people are seeing this as a damning indictment of the backing for ‘austerity’, will this have any impact on the approach to the eurozone crisis?

In a word, no. Here are a few reasons why:

• R&R research aside it is clear to everyone that Greece, Portugal and Ireland were insolvent, it was market pressure that pushed them into a bailout. Reducing the debt level is a vital part of their reform, while it also serve to counter the significant moral hazard that comes with a bailout.
• Similar constraints apply in Spain, Italy, Cyprus and Slovenia. With elevated borrowing costs they cannot expand fiscal policy without coming up against greater market pressure and pushing their average interest costs well above their growth rates (especially in the short run).
• Therefore, arguing for the end of austerity in these countries is actually arguing for fiscal transfers from the rest of the eurozone, since they do not have much, if any, room to expand spending. This is ultimately where the debate is at, it is not about austerity or spending, it is about whether the stronger countries are willing to provide the transfers – be it through banking union or fiscal union – to keep the eurozone together in the longer run and create the architecture necessary so that it can withstand future shocks. If they are not then they have to face the prospect of breaking up or decreasing the size of the eurozone.
• The constraints which apply also extend much further than just public debt. As we have seen in Spain, Ireland and Cyprus (and are seeing in Slovenia) the levels of private sector and banking sector debt are equally important. The macro picture is much more complex than just the level of public debt and economic growth. The problems in the crisis are a mix of fiscal, banking and structural.
• Austerity is more than just cutting spending. It has become a catch-all term for some very necessary reforms to improve competitiveness and productivity in the eurozone. Even if spending could be increased, these reforms would be needed, although admittedly the fallout (increased unemployment in many cases and massive political backlash) might be more bearable – but as noted above, this isn’t really possible in many of the worst cases.
• The logic behind the current approach is also strongly driven by Germany’s own economic experience in the late 1990s and early 2000s, which proved very effective in turning the country around. The main issue here is not whether the approach itself is correct or not (since it clearly did work there), but the scope in which it is applied. It is clear that you cannot have 17 Germanys with economies driven by exports in a single currency bloc where the countries predominantly trade with each other (it might help in the short term but its not clear it is a sustainable long term economic model for the bloc).

So what academics (and policymakers) really should debate is whether fiscal transfers are possible and/or desirable.  Proving or disproving R&R is neither here nor there when it comes to dealing with the eurozone crisis.

Initial thoughts on Spain's latest austerity budget

We’re still waiting for the full breakdown and figures behind the Spanish budget (which we will analyse and post in due course) but in the meantime here are our initial thoughts:

• The decision to tap the pension/social security reserve fund for €3bn was surprising. Generally this is a fairly last resort approach, but why Spain felt the need to do this to get its hands on only €3bn isn’t clear, especially with short term borrowing costs still low. Could Spain’s liquidity problems be greater than thought?
•  The interest Spain will have to pay on its debt will go up by €9.7bn, compared to a total package of cuts of €40bn (undoing almost a quarter of them). For a country the size of Spain even seemingly substantial cuts can easily be offset by the massive debt burden.
• The majority of the savings (58%) will come from spending cuts rather than tax increases – there is an on-going debate over which is more effective but in the short term spending cuts are likely to harm economic growth (especially given the reliance on the state as an economic driver in Spain).
• Tax revenue is expected to go up by 3.8% - given that growth is likely to falter this seems incredibly optimistic, even with some tax increases.
• The basic macroeconomic forecasts for the budget haven’t changed – this suggests that the overly optimistic growth forecasts are likely still in place, despite most investors and international agencies reducing their forecasts.
• Unemployment is predicted to have topped out this year – again this seems hopelessly optimistic given that structural labour market reforms are yet to take full effect (and there are still more to come) while internal devaluation will need to continue at a rapid pace (see our recent briefing here for more info on this).

So, plenty of issues already, with what seems to be a fairly unconvincing budget given the state of the Spanish economy. 

One final point to note is that Spanish Economy Minister Luis De Guindos kept insisting that the measures were all in line with recommendations from the EU/IMF/ECB troika or in some cases even went further. This looks to be leading into a Spanish reform programme as part of a bailout/bond buying scheme, hinting that Spain may be preparing that request after all.