26 February 2013

Martin Wolf: The sad record of fiscal austerity

Nevertheless, I can see two arguments for the ECB’s behaviour. The first is that help could only follow a demonstrated willingness to embrace austerity. Second, as the latest European Economic Advisory Group report rightly notes, the real problems have been destabilising capital flows, external imbalances and worsening competitiveness, not fiscal deficits. But one can justify fiscal austerity, brutal though it is, as the only way to force adjustments of relative costs and the needed labour market reforms. My colleague, Wolfgang Münchau, argues that the opposite is true. But I wonder whether the eurozone will survive its cure. Countries in the core would be better off themselves if they gave the weaker more time to adjust.

Countries outside the eurozone have been in a very different position. They had no need to fear the rising spreads of eurozone members because they did not face similar liquidity problems. To a first approximation, the yield on UK or US sovereign bonds should reflect expected future short-term rates of interest, with a small risk premium, since outright default is inconceivable. The widely held view that yields could soar is a bet on a surge in inflation. While inflation has been stickier than many expected, such a surge seems unlikely. Monetarists can note that the growth of broad measures of the money supply is low. Keynesians can note the excess savings of the private sector. Neither points to rising inflationary pressure.

Thus the panic that justified the UK coalition government’s turn to a long-term programme of austerity was a mistake. Had its members never heard of the paradox of thrift? If the domestic private and external sectors are retrenching, the public sector cannot expect to succeed in doing so, however hard it tries, unless it is willing to drive the economy into a far bigger slump. While short-term factors have played a real part, it is not surprising that the UK’s recovery has stalled and the deficit is so persistent. It is consequently also not surprising that downgrades are on the way, not that these tell one anything very useful in the case of an issuer with access to its own money-printing machine.

© Financial Times