Austerity Has Made Europe's Real Problem Worse
Austerity backfired by making public deficits worse
May 30, 2013
Austerity – meaning excessively fast and large public spending cuts and tax increases – has been worsening Europe's real problem which is loans that went bad. Austerity has also backfired by making public deficits worse. This economic policy approach was never demanded by markets, it was just a mistake. The euro area governments are right to ease off on the pace of fiscal consolidation.
What went wrong in Europe during the 2000s was similar to what went wrong in the U.S. Banks and investors made bad bets on real estate and other overpriced assets that crashed. The key difference is that in Europe most of the lenders were in the northern or core countries of Germany, Holland, Finland, and France, while most of the borrowers and crashed markets were in the southern or periphery countries of Ireland, Italy, Portugal, and Spain. So after the crash, people worried that the loans to banks across borders wouldn't be repaid in full – that is, that borrowers would default in a way that say, mortgage holders in Nevada wouldn't on loans from New Jersey.
What does public sector austerity have to do with fixing this problem? Good question. The answer is not much. The way to resolve the euro area default panic is to set up a system of bank supervision and of restructuring loans that is trusted to work across European borders. Cutting public spending and raising taxes just makes more loans go bad and fewer banks get properly recapitalized, so the problem gets deeper.
Austerity in Europe, however, didn't just address the wrong problem – it also worsened the problem it was meant to address, government debt. When you raise taxes or cut government spending, it is meant to close the gap between revenues and expenditures. But a national government isn't the same as a household. When it cuts spending or raises taxes it also cuts growth of the economy, which right away increases spending (on things like unemployment insurance) and decreases revenues (because people have lower income and pay less taxes). The net impact on deficits between these two effects depends on the situation.
As some of us predicted, the euro area crisis was exactly the wrong situation for austerity to produce lower deficits. In a recession, the impact on growth of austerity is much bigger than in normal times; ditto for when a country's banks are damaged. And when your neighbors cut back at the same time as you do, the growth effect gets reinforced, especially if you trade with them a lot (which the euro area members do). Throw in the fact that the European Central Bank didn't loosen credit enough to offset the fiscal contraction, unlike the Federal Reserve, and you have a recipe for austerity producing increased public debt.
And that is precisely what has happened. So the euro area governments are right to back off on austerity, to keep both their public- and private-sector debts from rising. They need a new approach to their problems.