16 January 2012

Iannis Mourmouras: The price of austerity for indebted Greece

In his article for the FT, deputy Greek finance minister Mourmouras writes that the austerity programmes in the eurozone's periphery have been unsuccessful, not only because of problems with their implementation, but also due to their incorrect design.

The gross inefficiency of the fiscal policies implemented in the eurozone’s periphery is alarming. A conundrum arises when a country, trying to reduce its budget deficit through austerity, ends up deeper in recession and more indebted. As the economy contracts and prices fall (in an internal devaluation), nominal GDP drops and thus both the debt burden and the debt-to-GDP ratio simultaneously increase.

The crucial question is how this conundrum can be resolved. Our proposed solution regards the main “target variable” of the austerity programme. Any fiscal consolidation in a highly-indebted member country of a monetary union should target not the overall fiscal deficit (which is cyclical), but instead the structural deficit. The failure of austerity programmes in the eurozone’s periphery can be attributed to this significant technical mistake in their design. Taking permanent austerity measures to reduce a cyclical deficit will only deepen and prolong a recession. Empirical evidence suggests that the most efficient way to tackle a structural deficit is to focus primarily on expenditure. That means significant cuts in public expenditure including the closure of outdated, loss-making, public sector entities.

As for the cyclical deficit, it will correct itself through the economy’s automatic fiscal stabilisers, provided that measures to enhance growth (still missing from the periphery’s adjustment programmes) supplement fiscal consolidation. Such measures should include Europe-wide projects and, at a national level, front-loaded payments from European Union structural funds, self-financing concession contracts (for ports, regional airports, highways etc.), public private partnerships, and so on. This policy mix – targeting the structural deficit and taking low-cost measures to boost growth – would stabilise the economy at a new equilibrium. This would allow the private sector to again form positive expectations, resulting in a second round of positive changes in private spending and income.

Full article (FT subscription required)

© Financial Times