Posted on January 19, 2012 - by invest

Austerity is a pain. So is tight money

AUSTERITY in the euro zone has been under attack ever since the first economist representing the troika (IMF, ECB, EU) set foot on Greek soil. Actually, the troika may become more of a duoika (?), according to Athens News (via Tim Duy), because the one-sided emphasis on austerity is enervating the IMF.

I think this is as good a time as any to review why austerity could harm the economy, and whether there is a difference between regional austerity, and euro-zone-wide austerity. After all, some readers may wonder: should a highly indebted country stop saving?

The main argument for why austerity hurts the economy is that in times of insufficient aggregate demand, a further cut in government spending takes away the only player willing to borrow and spend instead of hoarding cash. However, the central bank has a big say in how much cash people want to hold and how much they are willing to borrow and spend. A recent IMF study on austerity confirms that monetary policy plays a large role in whether austerity hurts the economy or not. What follows in most economic theories (see Mankiw and Weinzierl or Woodford for recent treatments) is that government spending changes have only minor effects as long as central banks are unconstrained. Are they?

The central bank of a small open economy like Britain is almost never constrained because a policy of last resort, currency devaluation, is always possible—as the Swiss Central Bank recently demonstrated. Swedish economist Lars Svensson calls this “the foolproof way”. Therefore, if David Cameron’s austerity policies are hurting the economy, then the main reason is that there is either political pressure on an otherwise unconstrained central bank or technical obstacles that prevent it from stabilising aggregate demand appropriately.

The central bank of the euro zone is unlikely to be constrained, either. It could, at least in theory, counteract euro-zone-wide austerity and compensate for the shortfall in aggregate demand that such measures are likely to entail. Should it hit the zero lower bound, or should banks face unreasonably high funding costs despite low interest rates, the issue gets a little more complicated but is not necessarily unsolvable.

What about, say, Greece? After all, it doesn’t have a central bank with independent powers to set monetary policy according to its needs. Recent research suggests that government spending has a large effect on the economy in exactly these circumstances, in which monetary policy is not set at the national level but by a supranational or external authority. Austerity will therefore hurt these countries: at current levels of prices and wages, aggregate demand in Greece is insufficient, and fiscal austerity eats further away at it in the absence of a central bank to pick up the slack.

This seems like a trap for an over-indebted country in a currency union. And to some extent it is a real dilemma. However, it reveals three important lessons for governments, the troika and the ECB.

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