Austerity as a substitute for trust

Here is a common view, not incorrect as far as it goes:

Struggling euro-zone economies like Greece, Portugal, Spain and Italy cannot cut their way back to growth. Demanding rigid austerity from them as the price of European support has lengthened and deepened their recessions. It has made their debts harder, not easier, to pay off.

And here is a useful Paul Krugman post on austerity, perhaps the best single (brief) statement of his views on European austerity.  Three observations:

1. I have yet to see a numerical analysis of European fiscal austerity which adjusts for a) falling ngdp, b) the collapse of their banking systems, c) and the collapse of M3 and money markets in some of these regions, noting that in Italy there are partial (very recent) signs of a money market turnaround.  The blame gets pinned on the fiscal austerity.

2. I have yet to see a numerical analysis of European fiscal austerity which considers the prospect of later catch-up growth.  This can make the costs of austerity much smaller, though of course from discount rates and habit formation there is still a cost.

3. Ideally it really would be better to say “Italy, I trust you to cut spending later, after your economy has recovered.”  This cross-national trust is not present, least of all with Greece but also elsewhere.  What is the best available policy in the absence of this trust, knowing that the periphery nations have to send some kind of credible signal to the wealthier nations of the North, in return for ongoing aid?

You can think of those three points as the “frontier reasons” why not all economists agree on European austerity.  There are indeed some “dY/dG denialists,” but there are too many attacks on them and not enough explorations of the real issues.

Ironically, postponing austerity is most likely to succeed when there is lots of trust in a country (and in fact whether or not that trust is deserved).   You can imagine the Swedes agreeing to themselves “we’ll cut spending three years from now” but the Greeks not, not without external constraint.  Thus, writers who unmask the depravity of the American polity, and who polarize opinion, are oddly enough doing harm to the anti-austerity point of view.

You will find an alternative perspective on intellectual strategy here.

Here is my earlier dialogue between Fabio and Angela.


I think here's the cruicial distinction between a currency union of the US and Europe. It's not really about the central government rebalancing (in the US there are severe imbalances between states, even more so than in Europe), but everyone knows that in a crisis, the federal government can stick a gun (literally and figuratively) to the heads of the people involved and force a solution. Eg in 1941 when the RFC bought Arkansas's entire bond issue, saving the state from default.

My guess is that no government in Europe really wants austerity, but its the only solution that everyone who has power (ie the national governments) can agree on without risking losing the next election.

What if the economy doesn't improve? What if the conditions that created the debt problem in the first place prevent economic growth and would only be perpetuated by continued injections of cash?

What if it isn't austerity that is causing the problem, but the fact that the Italians read Tyler's blog telling everyone that the solution is to take the wealth of Italians to fund their debt, and they rationally moved their assets so that it couldn't happen?

Maybe what is happening is a game of who is the sucker. I think the Germans are figuring that out and don't like the answer. I'm quite sure it hasn't been lost on any of those sitting at the table that what Greece needs is not much more than what gets auctioned in a week by the Treasury. Reading Krugman gives them hope that another sucker will show up at the table.

"What is the best available policy in the absence of this trust...?": slaughter the firstborn.

I agree that austerity shouldn't be the automatic solution. But I thing we have a human problem, people who take the decision about what economic policy must be applied are more familiar to firm functioning than macroeconomic. In period of tension and panic, they seem to choose what look the more logical for them; downsizing. That why political leaders are more likely to choose austerity policy, they are lowering debt, save cash and wait for better days. The question is why economists who make proposals to leaders always show austerity plans? It is criticisms which were already made for the IMF after the Asian crisis, and IMF staffs are not suppose to panic during financials crisis! Accusations have been made that this kind of policy is partially efficient, to preserve capital, creditors and from contagion risks. But I believe that an economic policy must be efficient in first for the bigger part of people in a country and short term decisions mustn't negatively impact middle term goals for majority .
The last example is the Greek minimum wage cut of 22%, everybody talk about competitiveness and growth recovery but there are still remaining questions.
we made a post on this, in the spirit of the questioning about austerity.
And Rebecca Wilder too.

Trust will not make broke countries less broke.

Austerity doesn't "work" of course in the sense that you prosper through it. Austerity is the hangover from having been drunk. And it is nevitable and unavoidable,

I disagree. Austerity does work in one sense - it is a signal. It is a signal to investors that governments will make tough choices if they have to. It is a signal that the government is willing to take the backlash from voters to do the right thing.

That's a signal you want to look for when you're investing your pension.

I don't understand it; honestly, if you are like Greece with obviously bloated government sector, over-paying people, paying people to do nothing... And now you enact austerity measures that aims to stop this. Unless you argue that austerity measures ultimately end up hurting the useful things while doing nothing with the bloated government, or that the austerity program somehow causes people 'not to work' (compare Greece strikes vs. Baltic states), I really don't understand how this could make anything worse.

And I don't really understand Krugman; he admits that there can be reverse causation, yet he still claims this as a proof of the proposition to be true? I mean: you know, my proof of Fermat's theorem is wrong, but isn't it an nice obvious illustration why Fermat's theorem holds? Huh?

BTW: if you have a lot of government bloat, lot of corruption and a lot of useless government spending, than a portion of GDP attributed to the state is miscounted as positive and a portion is double-counted as transfer. I doubt government statisticians are good in discerning these things in government-deflator-like statistics; thus, almost by definition, if you encounter effective austerity measures, GDP statistics will go down, although the real production (in terms of what GDP should measure) may as well go up.

It seems to me Greece is way beyond just cutting the job of a bureaucrat who doesn't show up for work. Pension cuts (round 3) cutting funds for medicine, auctioning off state assets, not to mention further eliminating government jobs. If you have a view that almost all government spending is problematic, then you prefer austerity despite overall consequences.

I have never heard of the argument you cite in the second paragraph. Could you provide a link or more information?

You can argue that austerity in public-choice environment means 'cutting productive government' and therefore austerity won't work. Who argues this way? I didn't see anyone.

Minimum wage in Greece is ~ 640euro. Minimum wage in Czech republic is ~ 320 euro. My guess is that you cannot get much worse by cutting these things 50%... Similar per-capita GDP. Living in Czech republic and having visited greece a few times I would argue that Greece is vastly less productive (they have better tourist areas though).

As for the argument: if a government buys something for twice its 'market' price, it is equivalent to a transfer + government expenditure. Unless the statisticians track this information and reduce government expenditures appropriately, it seems to me that corruption grows gdp, as the 'transfer' part is double-counted (or not-subtracted). Corruption/overpricing is to be expected to be very significant in Greece, therefore this could make an effect. Am I wrong?

+1, this problem is endemic to macro. As the rant Tyler linked the other day suggested, you can't truly aggregate demand because it isn't really made of fungible things.

Because of this it is entirely possible for "real GDP" to fall even as actual production of things people really want (i.e. satisfaction of true demand as opposed to production of things people generally don't want) is increasing.

Thanks for the explanation.

I think that the current deal proposed will not work. The dramatic changes in lifestyle due to cuts will add up--the worst has not hit the general populace yet--and people, more people, will be in the streets. The outcome will be negative.

I am not sure corruption/overpricing gets any better under austerity. People get desperate when usual sources of revenue and jobs are cut it, and it could make those very same problems worse.

Krugman's point is that, even if you believe the graph shows reverse causation, there is still zero evidence for "expansionary austerity" in it.

That was an excellent post, which I think points out the true weakness of the Krugman argument. He's right on the economics, but the economic argument simply doesn't account for the politics of the situation.

It's also regrettable that Keynsians weren't making sufficient (or in some cases, any) noise about governments running deficits during the boom times.


Firstly, Greece was lying about the size of its budget deficits for quite a long time. I don't see how Keynesians could have called them out on that.

Second, if we reduce all Keynesians to Krugman (as seems to be the trend in the comments section here) were noting exactly this problem as far back as 1998:

Thirdly, both Spain and Ireland ran significant surpluses in boom times (see: and yet more austerity is being demanded from them. Their governments were highly responsible (at least in the realm of feasible democratic governments) and yet their citizens are still being told by the EU central bank to go pound sand.

In fairness, Greece's problems did not arise overnight, those issues have been known for quite a while but were ignored until very recently in the spirit of EU comity.

In that 1998 piece, Krugman warns of German budget deficits. Not exactly the problem that turned out to matter. What would have been useful is something along the lines of "Euro countries face a demographic crisis so they had better start implementing counter-cyclical austerity now, rather than during a future recession when it becomes necessary to avoid default but is much more painful and not counter-cyclical."

Running a surplus once in a while isn't enough if your baseline budgeting demands you spend yet more in the future and a recession would drive your gov't to default. Again, this isn't something that wasn't known long ago (just as we know today there are similar problems coming here in the U.S.). And for all the talk of "austerity" (which should be read as "solvency" i.e. a level of spending a country can actually afford) we're still not seeing a lot of cuts in real terms across the EU.

Greece's problems were not understood to be so serious until the Greek government revealed that they (with the help of Goldman Sachs) had been fudging official numbers for years:

I suppose if you're a close watcher of Greek budgets you might have spotted something was amiss, but I don't think that's a standard to which you can hold most macroeconomists.

As for Krugman et al. championing running surpluses (or at least moderate levels of debt) in good times, it hardly which country they recommended do it; 1998 was good economic times and Krugman is warning Germany not to stray from the path of solvency lest hard times hit. Ireland, Spain, Austria, Germany, and others all followed standard Keynesian macroeconomic advice of running low levels of debt to GDP and for what?

Only to be told in bad times that they must introduce punishing levels of austerity. The immediate problem has nothing to do with demographics. It's not like half of Spain died yesterday. The problem is that money in < money out and governments are told to take steps that will only further decrease money in. Compare the situation of Spain or Belgium to the UK - Spain (Spain had one of the lowest debt to GDP ratios in the Eurozone: and Belgium budgeted very responsibly in the 2000s while the UK more or less muddled along. However ,the UK has enacted fiscal and monetary stimulus that prevented their economy from cratering after 2008, while Spain and Belgium have been in free fall. Thanks to the RBC inflation hawks at the EU central banks.

Greece's problems were well-known long before the Goldman Sachs issues. They have a broken civil society, with endemic corruption. This was discussed when they entered the EU, but glossed over and ignored until the problem blew up in the Eurocrats' faces. They got exactly what they should have expected.

Krugman's main point seems to have been that the Germans were captive to a deflationary regime they asked for but no longer wanted, he mentions the different trajectories of German and French deficits only in passing. He does not argue for the widespread spending cuts that would have prevented this crisis, and as best I can tell he never has: he's a statist, not a Keynesian, at least in his policy writing.

Again, everyone knew this was coming. This crisis didn't appear out of nowhere, unfairly requiring austerity in a recession, the demographics had been recognized and talked about decades before, but were ignored until the recession struck You cannot look at their budgets absent the demographic picture -- debt to GDP ratio is not very meaningful if a country has future obligations it can't pay for. Even if they run a primary surplus, like Italy, the bond markets are still going to ask how they expect to pay for planned future spending.

Oh really? How come Ireland was so badly affected then? They have one of the highest population growth rates in the EU:

Furthermore, due to migration and a major *increase* in the fertility rate, Italy experienced unprecedented population growth in the last 10 years:

Spain also experienced significant population growth due to immigration:

These countries are also experiencing some aging of the population, but most immigrants are working age and have high fertility rates (not to mention a lesser claim on state benefits), so there's no reason, as long as immigration keeps up, that this can't continue into the future.

Yes some structural adjustments will be necessary but modest deficits today (let alone surpluses) should have been plenty to tide these countries over until a structural adjustment was necessary. There is no huge future claim on revenue, as you claim there will be.

The current problem has exactly nothing to do with demographics in Europe, and only someone uninformed would think so.

Ireland had much more bank exposure.

Italy still has a demographic time bomb to go along with productivity stagnation, as Tyler has pointed out before. So does Spain.

The problem is those young immigrants don't have enough jobs. Look at those youth unemployment rates! All they've done is burden the state with yet more problems.

The bond markets are not uninformed.

This is also why, btw, the PIIGS are being urged to do things like raise their retirement age.

Italy has a demographic time bomb only if you ignore immigration. The number of white Italians will be in free fall, but not the Italian population.

Almost every analysis of the Italy/Spain/Europe population bomb scenarios does not account for the role of immigration. Net immigration into Italy is about 4.5 per 1000, the birth rate is about 10 per 1000 and the death rate is also about 10 per 1000. If you assume the birth rate stabilizes there (it's been rising, but for the sake of argument), the death rate could go up 50% and you'd still have a stable-state population.

So, there is no huge future problem for tax revenues so long as immigration policies remain fixed. As you yourself point out, Italy has labor market structural issues that leave the current youth underemployed. So in a sense they already have a large reservoir of working-aged people that they have yet to tap anyway.

It isn't just population, it's the average age and the productivity. You're going to have too many retirees and too few workers. And Europe is already having problems with assimilation, and unemployment is higher among the young immigrants -- it isn't enough to import low-skill workers, Italy needs to grow productivity as well, and that just isn't happening right now.

If this wasn't a problem, the bond markets wouldn't be concerned about rolling over Italian debt.

It's because Krugman is a statist, not a Keynesian.

It's possible to be both, consistently.

In the cases where they diverge, he is a statist.

In good times: raise taxes.
In bad times: Increase government spending

Accompany with whatever appropriate monetary policy. Consistent, statist Keynesianism

In good times: cut government spending
In bad times: lower taxes.

Consistent anti-statist Keynesianism.

It's really not too hard to figure out.

I didn't say it wasn't possible, I said he where they diverge he is a statist. Was that so hard to understand?

I'm sure I've wasted far too much time on this semantic nonsense already, but since you don't seem to understand: obviously it is also possible to be inconsistent by arguing for raising taxes in bad times and increasing spending in good times, so your point is irrelevant.

Uh oh, this looks like a repeat of the semantic fun that ensued when you confused "our democracy" with some nonexistent classical democratic ideal that disallowed free speech. On second thought, I'm going to pass, thanks for stopping by though.

Is it really so difficult to understand that democracy and liberalism are different things?

Apparently it is, for you.

"Our democracy" is a consitutional republic.

Yes, I understand perfectly: you like to raise irrelevant semantic quibbles. Good luck with that.

I agree with Nigel. I cannot understand why more economists in 2012, and for some reason those that call themselves heterodox first and foremost, can't come up with a theory for the real world including the blatantly obvious political constraints.

They keep saying austerity, but mostly I just see tax increases.

The austerity is a vainglorious attempt to save the euro. Greece will face the austerity of the market if they leave the euro, but their economy will see a positive shock just from all the tourists pouring in and start growing immediately.

Those advocating for higher deficits do not understand the loss of faith, nor even the nature of the problem. Austerity doesn't work when you have too much debt; when you have too much debt you declare bankruptcy. Greece is bankrupt. Other European nations are also near bankruptcy. If more debt is piled on to save the system today, the loss of faith will increase, not decrease. And then one day, like Lehman Brothers, the European banking system or the euro cease to exist.

I agree. Austerity won't save you if you have too much debt to finance.

Debt doesn't matter. You can forgive debt.

This is about Greece living on tax receipts.

And they won't get the tourism, if they don't go beat the rioters in the streets.

The less productive have to eat less food, take less vacations, use less healthcare, and on and on and on... and until you hit rock bottom, and become really good at making rich tourists feel awesome about themselves, you be screwed.

If you fail to align the incentives, then you will require a socially conservative solution: trust (and we're back to Jeffrey Sachs). Trust is, let us be clear, the ascendance of agency, that promises made to creditors will be kept. It implies politicians will represent, in the future, the obligations made today, rather than taking an easier route more aligned with domestic political acceptability. I prefer relying on self-interest, and that means aligning the incentives of Greek decision-makers with those of the creditors. If the incentives were aligned, a deal with Greece would be possible. (After all, what is it that the EU really wants to buy here? The money is gone and won't be repaid--so there's little reason to harp on this issue. Rather, the challenge is to create a modern Greece, one based on meritocracy and open markets. The real prize is a Greece which is a true, sustainable, and fully integrated member of the EU.) But this will be achieved only be breaking traditional molds and alliances, and that will only be accomplished by aligning the politicians' individual self-interest with that of the EU, IMF and ECB. But the Troika not only refuses to do so, but even to talk about the topic. So Greece will default, and the Troika--and the rest of us--will reap what a lack of imagination and unfettered analysis will dictate.

There are two fundamental problems. Mankind’s first serious attempt to deal with the challenges of retirement, health care, financial security, housing, employment, and sustainable economic growth
aren't working. With no good options, government is paralyzed and trust in governmental elites is collapsing.

There is no good reason to trust government until and unless structural reforms are implemented that at least create the possibility that the systemic vulnerability of representative democracies to the creation of long-term entitlements/guarantees that benefit special interests and current office holders but that will fail over time.

This comment really deserves its own blog post!

I'd propose that austerity is the correct answer here, but not for the reasons we are being given.

Greece is not going to grow its way out of the crisis - Greece is going to fall, hard, to a consumption level that is appropriate to its productivity. A sharp correction is unavoidable.

Austerity serves as an excellent mechanism to provide for an orderly, humane, and economically efficient transition from their current level of over-consumption to the corrected level.

How better to sharply lower the standard of living of an entire nation, without recourse to inflation?

Tyler, to me this is one of your best posts this year.

You lost me at "Paul Krugman".

Since when does a geographic area actually have to have a government to have economic growth? Since when does a government have to spend 50% of national income to have economic growth? For over 100 years, the Federal Government of the US spent less than 3% of national income and the US had substantial economic growth.

Would reducing the spending of the Greek government by 90% cause disruption? Yes. Would it destroy all possibility of economic growth? Hardly.

"I trust you to cut spending later, after your economy has recovered." Who trusts the Italian parliament to do that? Who trusts the U. S. Congress with the same mission?

I want DeKrugman to live to a fine old age, and when he dies, I want him to go peacefully surrounded by loving friends and family, and when he is laid to rest, I hope there is much wailing in the streets, and then when it is all over, I'm going to pay to have a couple of little kids open up an illegal lemonade stand on his grave.

I will promote it far and wide, and the line will reach for miles, the price of lemons will spike; and that, is all anyone will ever remember about DeKrugman: legitimate commerce over his dead body.

"The vitality of empires, as we have often pointed out, is built while people are still relatively free. The primary recipe for creating great cultures (as opposed to great empires) has to do with serial municipal environments that are fairly close geographically but are nonetheless competitors, even though the languages are the same or similar.

This state of affairs, which emerges throughout modern history, allows the most productive and often the most rebellious people to move from one place to another with their families when oppression strikes at them. Not only that but the competition inherent in these regional environments makes them freer as a general rule.

What are some examples? We've provided them in the past. The Greek Golden Age was the product of disparate Greek city-states. Rome was ultimately the product of the Seven Hills. The Renaissance was the product of Italian city-states. The American empire was ultimately the result of 13 separate states as well.

As for Britain, we would speculate that a historical accident made it the center of cultural currents that swirled about Europe for most of its post-Neolithic history. Wikipedia explains the following: "Anglo-Saxon England until the 9th century was dominated by the Heptarchy, the kingdoms of Northumbria, Mercia, East Anglia, Essex, Kent, Sussex and Wessex."

Later on, of course, England was "consolidated." But that's what happens with all great cultures. They start out free and end up being homogenized. This centralization of a great, free peoples gives the empire a residual energy – entrepreneurial and otherwise – that fools people into thinking it is the "empire" that imparts greatness to the culture. But it is actually the other way round.

An empire is always a culture's death knell. One only has to look at Britain (or America) to see what happens once an agglomeration of people becomes an "empire." To begin with, an empire's leaders always look outwards because they are trying to impress the benefits of authoritarianism on their already brow-beaten subjects. But eventually empires start to collapse and all that outwardly-aimed aggression and hostility rebounds and pounds the domestic population into further subjugation."
-The Daily Bell

Cut the handcuffs the money printers are trying to keep the people in. Default on the debt, make the banks eat it. Go Iceland and tell the EU to buzz off.

How is the increase of government spending supposed to work?

If it's done by having the government "randomly" buying/funding stuff, this seems utter folly, since the money would almost surely be mostly wasted, especially in countries with high corruption like Greece and Italy.

If it means lowering taxes or equivalently paying dividends to citizens, then the problem is that this requires the government to take additional debt/not repay debt, which is also bad due to the high rates due to the debt crisis.

If there was a recession without a sovereign debt crisis, then taking up debt to fund tax cuts could work, but given the situation it seems any increase in government spending is counterproductive.

As per your first point: 1. I have yet to see a numerical analysis of European fiscal austerity which adjusts for a) falling ngdp, b) the collapse of their banking systems, c) and the collapse of M3 and money markets in some of these regions, noting that in Italy there are partial (very recent) signs of a money market turnaround. The blame gets pinned on the fiscal austerity.

The MMT guys argue that fiscal austerity causes those things, i.e., they argue that the only way to increase the money supply is for the government to spend money it has not taxed away or borrowed away from someone else. So, per their reasoning, fiscal austerity causes the effects that you mention. These effects are what Warren Mosler and company have been predicting for the Euro since day one.

The extra difficulty in Greece is that there is no government which can spend to increase the money supply since under the Euro the governmental functions of spending and printing money are segregated.

In matters of money, Greek citizens trust each other, especially in business-to-business transactions, less than anywhere I have been. Why would anyone outside Greece trust the Greek public service or Greek banks or Greek lawyers?

Why is it that I keep getting the impression that the "recession" is considered an unpredictable, tornado-like financial event unrelated to government activity and that the solution to this dilemma requires yet more government activity, only the funding of which is problematical?

As opposed to the equally vacuous sense that it is an unpreditable, tornado like financial event unrelated to free market activity and the the solution to this dilemma requires yet more free market activity, only the deregulation of which is problematical?

That's a strawman. The Austrian school warned of a recession as the predictable fallout from government and central bank intervention well before 2008.

The next bubble to go will be the one in sovereign debt.

That's a strawman. The Marxist school warned of a recession as the predictable fallout from unrestricted capitalist competition well before 2008.

The next capitalist crisis of over-accumulation to go will be the one brought about through sovereign debt.

I understand now. What passes for a free market, which includes tariffs, subsidies and regulations, is inimical to economic progress because voluntary exchange is less efficient than central planning as determined by genuis politicians like Chuckie Schumer and Patty Murray and their ivory tower acolytes. Evidently the western "free market" somehow sabotaged the planned economies of the eastern bloc, plunging the prosperous commies into poverty. It'll be a long while before we come to realize the dimensions of this tragedy.

You've made it clear that you don't really understand much of anything.

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