Six years after the onset of the global financial crisis, economists and policymakers continue to fight bitterly over how to tackle the world’s economic woes. Is fiscal stimulus the best medicine — or is fiscal austerity what’s needed?
For most of that time, the advocates of austerity have largely won out. In the U.S. and across much of Europe, governments have slashed spending in an effort to drive down deficits. While the specter of another Greece-like meltdown was behind much of the belt-tightening, austerity advocates also got a big boost from a 2010 study by a pair of well-known Harvard economists which found that high levels of government debt could substantially cut economic growth.
But with Europe sinking further into recession, the U.S. struggling to regain momentum — and the findings of the influential Harvard study now under attack — a backlash against austerity is growing. Economists and policymakers alike are raising new questions about whether stringent austerity measures have worked — or whether they are simply making a bad situation worse.
The complexity of the challenges facing the global economy — and the interconnectedness of many of the countries struggling to right their financial systems — makes that “a very difficult question to answer,” says Wharton finance professor Itay Goldstein. “Most economists will agree that having too much debt is not good over the long-term, but you certainly want to do any cutting carefully,” he notes. “If you’re going to cut expenditures or raise taxes quickly, that will have adverse implications when the economy is in recession.”
If all agree on the difficulties of the situation, however, the two main camps have taken diametrically opposed approaches to solving them. In one camp, says Goldstein, are latter-day Keynesians — those, like President Barack Obama and prominent liberal economist Paul Krugman, who believe that the government needs to ratchet up spending to help spur new investment and create jobs. When the economy is in recession, they argue, that is preciselythe time governments should run deficits to make up for the weakness in private demand.
“It’s macro-economics 101, one of the things we know from the days of the [Great] Depression,” adds Bulent Gultekin, a Wharton finance professor and a former governor of the Central Bank of Turkey. “It’s straightforward Keynesianism, but it works.”
Yet many prominent conservatives, from Republican leaders like House Speaker John Boehner and vice presidential candidate Paul Ryan to German Chancellor Angela Merkel in Europe, reject the tenets of Keynesianism outright. They view piling on more debt to pay for additional stimulus — which they largely deride as ineffective — as an anathema. To these “austerians,” as Krugman has tagged them, excessive government spending and ballooning deficits are the real problems — ones they believe pose an even greater long-term danger to the global economy than recession and rising joblessness.
“The problem is that if you keep running deficits, you end up where Japan is,” says Franklin Allen, a professor of finance at Wharton. “You’re better off to have deep recessions and grow out of them than these protracted periods of low growth and huge debts where the economy isn’t going anywhere; in 15 years, Japan has gone from being one of richest countries in the world to stagnation.”
The arguments of austerity advocates were bolstered by an oft-cited study, “Growth in a Time of Debt,” published in 2010 by Harvard economists Carmen Reinhart and Kenneth Rogoff. After looking at debt levels in 44 countries across 200 years, the pair argued that excessive public debt — specifically, debt exceeding 90% of a country’s gross domestic product — is associated with much slower economic growth.
With debt levels well above that theoretical “tipping point” in many countries — it now stands at 105% of GDP in the U.S. and more than 230% in Japan, while troubled European countries such as Greece and Italy have debt-to-GDP ratios of roughly 160% and 120%, respectively — conservative policymakers and activists have used the study to justify the need for sharp budget cuts.
A Wave of Belt-tightening
The result has been a cascade of belt-tightening measures in one country after another around the globe.
In the United Kingdom, Prime Minister David Cameron ushered in deep cuts in public spending soon after taking office in 2010, arguing that the reductions would ease pressures on the country’s credit rating and revive its economy. Across Continental Europe, Germany’s Merkel and the European Central Bank have insisted on sharp government cutbacks as the price of continued support and bailouts of troubled countries such as Spain, Greece and Cyprus. And in the U.S., President Obama has been stymied in virtually all attempts to increase stimulus spending since the Republicans regained control of the House in 2010; instead, government spending has been slashed and taxes have gone up.
If the austerity camp won the policy debates, the impact on the ground offers greater support for the Keynesian point of view. Rather than stimulating growth, says Gultekin, the sharp turn to austerity appears to be further damaging already weak economies and leading to sharply higher unemployment.
“Anyone familiar with basic macroeconomics would agree that when the economy is in serious recession and demand from consumers is down, it is only natural for the government to step in and increase spending so as not to have a more serious recession,” he notes. The push for austerity, which Gultekin dismisses as driven more by ideology than by economics, “just makes things worse.”
In the U.S., for example, a panel of private sector and government economists recently estimated that the unemployment rate, currently about 7.5%, would be almost a point lower and the economy would be growing almost two points faster this year if fiscal policies had not been tightened, according to a recent survey in The New York Times.
Europe, meanwhile, appears to remain mired in the recession that began at the end of 2011. For the first quarter of 2013, growth shrank 0.2% among the 17 countries that share the euro currency. The drop was sharper than expected as France returned to recession and growth in Germany stagnated. Italy, Spain and Portugal all shrank as well, while the U.K. managed to grow only 0.3%. As a result, unemployment in the eurozone hit a record 12.1% in March — and for younger workers, particularly in the troubled southern sphere, it is even worse: Unemployment for younger workers is 30% on average, and more than 50% in Spain and Greece.
To Mauro Guillen, a professor of management at Wharton, those numbers demonstrate a further problem with the European push for austerity. Even more than in the U.S., he says that it was “a big mistake” for all of the European countries to pursue austerity at the same time because their economies are so dependent upon one another. France is Germany’s largest trading partner, for example, while Germany is the most important market for Italy.
In other words, a spending cut in one country equals an income cut for its European partner. “It’s a very interconnected trade zone,” notes Guillen. “If every country pursues austerity at the same time, that will depress everyone’s economy, whether or not they have a government surplus. Who will buy your goods and services? Not your European partners.”
Given the growing political disaffection with austerity, Guillen predicts that the stringent programs will ultimately have to be eased. “Something has to give. It will not be easy to get out of the situation,” he says. “But unemployment is already unbearably high.”
The Research Debate
Moreover, even as the real-world implications have turned out to be more dismal than austerity advocates expected, the intellectual underpinnings of the stringent policies have also come under attack. In late April, a trio of economists from the University of Massachusetts, Amherst, published a paper showing that Reinhart and Rogoff made errors in the spreadsheet data used to calculate their results; in addition, the UMass researchers argued that other significant data was improperly weighted or omitted entirely from the Harvard study.
In a New York Times op-ed piece explaining their work, two of the UMass authors, Robert Pollin and Michael Ash, argued that the combination of issues means “there is no evidence supporting the claim that countries will consistently experience a sharp decline in economic growth once public debt levels exceed 90% of GDP.” They wrote that a high level of debt does not slow a country’s growth anywhere near to the degree that the Harvard economists claimed.
The discovery of the data problems has led critics like Krugman to cry victory and dismiss Reinhart and Rogoff’s arguments outright. But Richard J. Herring, Wharton finance professor and co-director of the Wharton Financial Institutions Center argues that the situation is nowhere near that simple. “I tend to think the flap over the Reinhart and Rogoff error is overdone,” he notes. While the mistake “was certainly disconcerting, thoughtful analysts have always understood there is no magic threshold between safe and unsafe levels.”
Reinhart and Rogoff themselves made much the same point in their own op-ed in the Times in response to the UMass paper. While acknowledging the error in the spreadsheet data (though not the other criticisms of their methodology), they stand behind their primary point — that excessive debt is dangerous. “Our 2010 paper found that, over the long term, growth is about 1 percentage point lower when debt is 90% or more of gross domestic product, ” they wrote. “The University of Massachusetts researchers do not overturn this fundamental finding.”
Limits to Debt
Many economists would agree with that.
Allen, for one, dismisses the idea that the UMass research invalidates Reinhart and Rogoff’s broader conclusions. “It doesn’t fundamentally undermine their argument,” he says. “There are limits to how much debt a country can run. Some go bankrupt with debt at 60% of GDP; others can go up to 200% or 300%. But we don’t know where that point is — it depends on a country’s individual circumstances.”
Allen believes Reinhart and Rogoff’s core idea is correct, even if their calculations were flawed. He points to Japan’s economy, which has suffered more than a decade of stagnation and deflation thanks in part to the overhang of enormous public debt. “We want to stay as far away from that point as we can,” says Allen. “It creates a situation that is much worse than deep recession.”
Still, the flaws in the study, coming at the same time as political pressure is rising to do more to curb unemployment, have led to calls for more a balanced approach between growth and austerity. Within the European Union, France, Spain and other counties faced with high unemployment and stagnant growth are pushing hard for Cameron, Merkel and the ECB to soften their stringent measures. Even the International Monetary Fund, traditionally a steadfast backer of austerity, has recently conceded that such measures may hurt growth far more than anticipated. In a move seen as little short of an about face, it has urged the U.K., France and others to ease up on the budget cuts and do more to bolster growth. And in Japan, the government has announced aggressive plans to double the money supply in hopes of spurring price rises that will end the country’s crippling deflation.
In the U.S., meanwhile, news that deficit reduction is occurring far faster than expected may ease the pressure for extensive new cuts beyond the current “sequester,” which is set to reduce government debt by $1.2 trillion over a decade. But that hardly means a return to looser fiscal policy, points out Greg Valliere, the chief political strategist for the Potomac Research Group, which provides insight into Washington policy for institutional investors. “More cuts are coming late this year as part of the debt ceiling debate — either an extension of the sequester or spending cuts to offset killing of the sequester,” he wrote in a recent research note. ”As for the hype that pressure will now grow for more spending — that’s not gonna happen; the House would never permit it. Our bottom line is unchanged: Strong receipt growth will persist – and with Republicans almost certain to retain the House in 2014, the spending restraint will continue.”