29 April 2012

Lawrence Summers: Austerity has brought Europe to the brink again

The prospect for success, politically and economically, depends on the restoration of growth. Only if growth is restored can the euro endure and European financial problems be resolved.

The cause of Europe’s financial problems is lack of growth. In any financial situation where interest rates far exceed growth rates, debt problems spiral out of control. The right focus for Europe is on growth; in this dimension, increased austerity is a step in the wrong direction.

Systematic comparisons suggest that when economies are demand-constrained and safe short-term interest rates are near zero, policy measures that reduce the deficit by 1 per cent have a multiplier of 1 to 1.5 – implying that a 1 per cent reduction in a country’s ratio of spending to GDP or an equivalent tax increase reduces its GDP by 1 to 1.5 per cent. Essentially, cutting deficits will have a disproportionately adverse effect on GDP because the multiplier is larger than 1 on the growth-reduction side of the equation. This means that austerity measures at the national level are likely to be counterproductive in terms of creditworthiness. Fiscal contraction reduces incomes, limiting the capacity to repay debts. It achieves only limited reductions in deficits once the adverse effects of economic contraction on tax revenue and benefit payments are accounted for. And it casts a shadow over future growth prospects by reducing capital investment and raising unemployment, which inevitably takes a toll on the capacity and willingness of the unemployed to work.

These considerations are magnified at the continental level. Slowdowns in one country reduce the demand for the exports of other countries. As a matter of arithmetics, increases in saving and exporting in some countries have to be offset by increases in spending and importing in others. Germany’s enormous success in recent years has been achieved by becoming a large-scale net exporter – it would not have been possible without large-scale borrowing and importing by Europe’s periphery. The periphery cannot possibly succeed in substantially reducing its borrowing unless Germany pursues policies that allow its surplus to contract.

Sceptics will rightly wonder how a prescription for more spending by countries that already have trouble borrowing can be correct. The answer lies in the difference between borrowing by individuals and countries. Normally, an individual helps his creditors by borrowing less; but a person who stops borrowing to finance commuting to his job does his creditors no favour. A country’s income is determined by spending, so a country that pursues austerity to the point where its economy is driven into a downward spiral does its creditors no favour. Yes, there will ultimately be a need to raise retirement ages, reform sclerosis-inducing regulations and restructure benefit programmes; phased-in commitments in these areas would be constructive. But the prospect for political and economic success in these endeavours depends on growth being restored.

Only if growth is restored can the euro endure and European financial problems be resolved. If there was ever a situation that called for a collective response, this is it. Going forward, the IMF and international community should condition further support not merely on individual countries’ actions but on a common European commitment to growth.

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© Lawrence Summers