Wednesday, March 21, 2012

Austerity, Stimulus, or Growth Now?

(This is also a Bloomberg "Business class" column, with minor improvements.)

Austerity isn't working in Europe. Greece is collapsing, Italy and Spain’s output is declining, and even Germany and the U.K. are slowing down. In addition to its direct economic costs, these “austerity” programs aren't even swiftly closing budget gaps. As incomes decline, tax revenue drops, and it is harder to cut spending. A downward spiral looms.

These events have important lessons for the U.S. Our government cannot forever borrow and spend 10 percent of gross domestic product each year, with an impending entitlements fiasco to boot. Sooner or later, we will have to fix our finances, too.  Europe's experience is a warning that austerity -- a program of sharp budget cuts and (even) higher tax rates, but largely putting off “structural reforms” for a sunnier day -- is a dangerous path.

Why is austerity causing such economic difficulty? What else should we do?


Lack of “stimulus” is the problem, say the Keynesians, epitomized by the New York Times and its columnist Paul Krugman, who has been crusading on this point. They claim that falling output in Europe is a direct consequence of declining government spending. Yes, 50 percent of GDP spent by the government is simply not enough to keep their economies going. They -- and we -- just need to spend more. A lot more.

Where will the money come from? Greece, Spain and Italy simply cannot borrow any more. So, say the Keynesians, Germany should pay. But even Germany has limits. The U.S. can still borrow at remarkably low rates, they point out. But remember that Greece was able to borrow at low rates right up to the moment that it couldn’t borrow at all. There is nobody to bail out the U.S. when our time comes. What should we do then?

The traditional Keynesian answer was: move on to monetary stimulus. Deliberately inflate and devalue. Break up the euro so the southern European countries can inflate and devalue even more.

Lately, Keynesians have been pushing an even more audacious idea: deficits pay for themselves. In a March 17 column, Krugman wrote: “there’s a plausible case that spending more now actually improves the long-run fiscal picture.”

U.S. Federal revenue is less than 20 percent of GDP. For deficit spending to pay for itself, then, $1 of spending must create more than $5 of output. Economists have been arguing about whether this “multiplier” is more or less than one; five is beyond any reported estimate. Keynesians made fun of “supply siders” in the 1980s, who made similar claims for tax cuts. At least those cuts had incentives on their side, which stimulus doesn't.

Is there another explanation, and a more plausible way forward?

The stimulus explanation is curious for what it omits. Think of Greece. Is it irrelevant that Greece is 100th on the World Bank’s “ease of doing business” list, behind Yemen, 135th on “starting a business” and 155th on “protecting investors?” Is it irrelevant that professions from truck driving to pharmacies are still rigorously protected, that businesses can’t fire people, that (according to a Greek colleague) you can’t even get a driver’s license without paying a bribe? Does it not matter at all that, as the International Monetary Fund delicately put it in its latest report on Greece, the “structural reform program” aimed at “deeply ingrained structural rigidities in labor, product, and service markets” got nowhere?

Does it not matter that Greece has a high combination of individual, corporate, wealth and social taxes, higher still under "austerity?" True, Greeks famously don’t pay taxes, but businesses that must operate illegally to avoid taxes are much less efficient.

Money is fleeing Greece, Italy and Spain. Does talk of exiting the euro, followed quickly by devaluation, inflation (the IMF predicts 35 percent in Greece, should it leave), and capital controls, have nothing to do with lack of investment?

Keynesians urge devaluation to gain competitiveness. Greek wages have in fact declined about 10 to 12 percent, according to the IMF -- so much for the impossibility of nominal wage declines. Yet investment and production aren’t turning around. Greek “demand” needn’t matter -- the whole point of the euro area is that Greece can sell to Germany, so long as Greece stays in the Eurozone. But it isn't happening. Is that a mystery? Would lower wages compel you to invest money in Greece, surmount a thicket of regulation, expose yourself to the threats of wealth, property and business taxation, currency expropriation and capital controls, or even nationalization?

In sum, isn't it plausible that a good part of Europe’s austerity doldrums are linked to “supply,” not “demand,” “microeconomics” not “macroeconomics,” weeds in the economic garden, not a want of fertilizer? Isn't it plausible that factors beyond simple declines in government spending matter in the economy’s response to a debt crisis?

That insight suggests a different strategy: Let’s call it “Growth Now.” Forget about “stimulating.” Spend only on what is really needed. We could easily stop subsidies for agriculture, electric cars or building roads and bridges to nowhere right now, without fearing a recession. Most "spending" is in fact transfer payments, which even Keynesian economics recognizes are not very stimulative, not the mythical (and curiously carbon-intensive)  roads and bridges, and most of that goes to people who are relatively well off

Rather than raise tax rates further on “wealth” and the “rich,” driving them underground, abroad, or away from business formation, fix the tax code, as every commission has recommended. Lower marginal rates but eliminate the maze of deductions. In Europe, eliminate the fears of wealth confiscation, euro breakup and currency devaluation that are driving saving and investment out of the south.

Most of all, remove the profusion of regulation and (increasingly) direct government management of the economy.

Growth is the key to paying off debts. The only way to escape large debt/GDP ratios is to embark on a decade or more of solid  growth. Growth like this comes from long-run productivity, not short-run stimulus. 

Europe is beginning to figure this out. Italy’s prime minister, Mario Monti, is addressing his country’s debt crisis by proposing far-reaching deregulation, now. While his proposals aren't complete or close to radical enough, and they are combined with some unfortunate business-stifling tax increases, it’s remarkable that anyone in Europe is beginning to talk about this approach.

“Structural reform” is vital to restore growth now, not a vague idea for many years in the future when the stimulus has worked its magic. Europe learned that it’s also a lot harder politically than the breezy language suggests. “Reform” isn’t just “policy” handed down by technocrats like rules on the provenance of prosciutto; it involves taking away subsidies and interventions that entrenched interests have grown to love, and support politicians to protect. They will fight it tooth and nail.

That is even more reason to address growth now, while there is a crisis. The will to do so will evaporate if better times return, and the ability to do so will disappear if the economies plunge.

19 comments:

  1. I agree with much of this, I guess I don't understand the binary nature of the discussion. Why is it strictly one approach or the other? when does that ever work in real life ?

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  2. binary

    what a wonderful word. that's why I read the comments. the writers so often have better thoughts

    binary---saves me from really ranting, thanks.

    as for "structural reform" it won't work; we all know it won't work. Martin Jacomb has written for two years in the Financial Times about why currency unions cannot work. Why do we continue to say they can?

    its a long story but the short version is location economics. there is no way for Greece, Italy, Spain, or Portugal to keep economic activity at home. it is easy to say grow and easy to blame all the usual suspects but the unhappy truth is that, even if, the south of Euro did everything John advocates it would make no difference. That is how powerful the location economic forces are.

    The action has been and is moving to Germany due to sound economic principles and forces about which there countries are pretty much powerless as long as they are on the euro.

    at whatever cost they need to leave the Euro, adopt their own currency, and use that powerful weapon to, over a long period of time, rebuild. Literally, hotel rooms in Rome and Athens need to drop to $50.00 a night. I just checked. Hotels on Hotel.com in Rome in April are still $250.00 a night.

    in sum, Greece, Italy, Spain, and Portugal should all: (1) leave the Euro; (2) be Keynesian; and (3) attack every inefficiency that can be found, per John

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  3. Ironically, the NYTimes just published a few days ago a story about one Greek's bureaucratic nightmare to start an olive oil export business. Finally someone serious is talking about deregulation where it matters - on Main street. I had a client who gave up after two years of trying to get approval to buy an ophthalmologist practice. He decided to home to Lebanon where he said he could up and running in three months. Wow! The US lost out to Lebanon!

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  4. JHC, Clearly the structural reforms you advocate would bring benefits. But I don’t think that detracts much from the “Keynsian / devaluation” idea.

    In other words if a country has excessive unemployment, plus a balance of payments deficit, plus it’s in need of structural reform, then the Keynsian / devaluation cure would work. At least that ought to deal with the deficit and the unemployment. But better still would be to deal with structural problems as well.

    Indeed, in as far as structural problems raised NAURU for the country concerned, then dealing with the structural problems would reduce NAIRU, and hence eventually would reduce unemployment still further.

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  5. You are mis-reading Krugman. Saying “there’s a plausible case that spending more now actually improves the long-run fiscal picture” is not the same as saying that "deficits pay for themselves."

    If you, Dr. Cochrane, go to Prof. Krugman and say that you want to spend borrowed money on productive infrastructure and repairs, education and research he would welcome you to the Keynesian fold.

    (What Greece needs and would work for them is not what the US needs and would not work for the United States.}

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  6. I agree with most of the conclusions, Greece needs reforms, as do Italy and Spain. However, while there are significant economic and political reforms that can and should take place, the problem is that a cultural shift is also required and this will take a generation, not just a piece of legislation. The labor market rigidities and the cultures of tax evasion are so engrained in the fabric of society that in the short term stimulus, to me at least, seems the only solution to the ongoing economic plight of Southern Europeans.

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  7. I did not understand your point. I mean, it is well established that the more hirizontal relations are in a society, the more eficient it is. It is interesting that when you understand it, you start seeing the industrial revolution starting with the Magna Charta...

    Indicators like how long does it take to open up a business are attempts to measure this reality - eficiency is a payoff of societal game. It is a simptom, not a cause.

    How do you want to tell people that learned through their entire lives how to survive and interact in this system, that they must through it all away and sart over from scratch a new kind of society where everything they know simply don't worth anything? Are you also saying that they must do it with the very same people and institutions they are interacting right now?

    How do you think the measures you have just purposed would work in field? I mean, in a society with verticalized institutions, how can you expect that measures like labor market liberalization does not transform itself into societal abuse? How the hell do you think it is possible to perform this kind change in the short run and during a kind of social ecatomb like the one those counbtries are experiencing? Why do you think it will work? I mean, what are you proposing in objective terms?

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  8. Dr. Cochrane,

    As a first year PhD student in finance fighting through supermodular games and risk premia, your blog is a welcome distraction. Thanks for taking time out of your busy schedule.

    Parth

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  9. Dear Dr. Cochrane,

    I am not sure what to think of your analysis. I agree that the difficulties in Greece are such that a stimulus, or austerity, will not work. But what does this mean for the problems in, say, Belgium, Ireland or Spain? Similarly, why does this tell us anything about the prospects of stimulus, or austerity, in the US?

    Different economies, different problems, different measures -- no?

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  10. The problem with the completely structural explanation is, why now? Greece's structural problems were very bad in 2005 as well. Do I think structural reforms are good for growth in Greece? Yes, of course, as they would have been in 2005. That said, nominal wages falling doesn't mean nominal stickiness isn't a problem. It means nominal stickiness IS a problem and adjustment happens slowly and not fast enough to restore employment. Are you confidenct Greece's nominal wage will not fall much further? Could you explain that occurrance in one year in the absence of major structural changes?

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  11. How do you explain Ireland within your cut red-tape mental model?

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  12. Sure everything went wrong in Greece so whatever your school of thought the Greek trainwreck is bound to fit within your model. As mentioned by other commenters I'd be curious to hear your thoughts on Ireland.
    If it's not too much deregulation (banks gone mad) and if it's not insufficient demand, then why is Ireland struggling? Ireland is already a poster child for deregulation. I don't see how it fits with the supply-side model.

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  13. John, a have a few key questions from this post, which I'll ask below. These are questions, or counters, at least some of which I'm sure you've heard or thought of. A big question is will you directly respond to them, or ignore them (as they're not mentioned and countered in this post).

    I know if you're trying to persuade, sometimes the best strategy is to ignore key counters, or holes, if you think the vast majority of your intended audience will never think of them anyway. So why make them known. But if you want to persuade economists and well educated laypeople, opinion leaders, who will think of these things, and/or may hear of these things, then it's best to directly address them, assuming you do have good valid counters. I hope you'll do that, so here goes:

    "U.S. Federal revenue is less than 20 percent of GDP. For deficit spending to pay for itself, then, $1 of spending must create more than $5 of output. Economists have been arguing about whether this “multiplier” is more or less than one; five is beyond any reported estimate. Keynesians made fun of “supply siders” in the 1980s, who made similar claims for tax cuts. At least those cuts had incentives on their side, which stimulus doesn't."

    Krugman said MAYBE they could pay for themselves in government revenues. But also:

    (1) You'd need $5 of output if you wanted payback in just 1 year, and if you didn't count increases in state and local tax revenues, which you should. Presumably the effects would last a lot longer than 1 year, especially if the stimulus were done in 2008. But, more importantly:

    (2), This is crucial, so I really hope you'll respond to it: Not all stimulus is, or need be, ditch digging, or consumption. What about the payoffs in future years from high social NPV investments like basic science and medicine (yes, improved medicine may not be reflected in GDP, but it should be; that's why I said SOCIAL NPV), education, alternative energy, smart infrastructure,... A stimulus bill could include tons of this; there's no shortage of such positive social NPV projects that we pass up year after year. And there was a substantial amount of this in Obama's stimulus bill, albeit not nearly enough.

    (3) Tax cuts have incentives on their side – Evidence please. You and most economists know well the income and substitution effects, the backward bending labor supple curve, and the fact that if people always work more hours when you increase their take-home pay per hour, why did the number of hours worked in the first half of the 20th century plummet at the exact same time that take-home pay per hour skyrocketed. MIT economist Jonathan Gruber, an expert in this area, wrote, in his 2007 textbook, "Public Finance and Public Policy", 2nd edition, "Changes in tax rates appear to have relatively modest effects on total gross income; the total amount of income actually generated through work or savings does not respond in a sizable way to taxation." (page 734). We need your evidence of these substantial incentives from tax cuts, John. Please don't just act like it's self-evident.

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  14. "The stimulus explanation is curious for what it omits. Think of Greece. Is it irrelevant that Greece is 100th on the World Bank’s “ease of doing business” list, behind Yemen, 135th on “starting a business” and 155th on “protecting investors?” Is it irrelevant that professions from truck driving to pharmacies are still rigorously protected, that businesses can’t fire people, that (according to a Greek colleague) you can’t even get a driver’s license without paying a bribe?..."

    Krugman and other esteemed Keynesian, center, and left economists I'm sure will agree that many of these things are very bad and should be changed. But here's the big question for you John: I'm sure these things were just about as bad 5 years ago, but the economy was vastly better. I'm sure these things were just about as bad in the mid-90s, but the economy was vastly better. So they don't seem to be the reason for the recent plummet, because they haven't changed. This was an argument also given in Japan. When the Japanese economy went south, people hauled out all of these structural problems, and a lot of them were real and serious, but they existed when the economy was booming too. So, while they may have made growth and wealth a lot less than they could have been, they don't appear to have been a reason for the slump. Why not fix these structural drags AND fix, or deal with, whatever actually caused the sudden recent plummet and years long severe recession?

    "Greek wages have in fact declined about 10 to 12 percent, according to the IMF -- so much for the impossibility of nominal wage declines."

    Yeah, but it took Great Depression-like suffering, a startling percentage of families homeless. Was it worth the suffering? Was there a far easier way?

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  15. "Forget about “stimulating.” Spend only on what is really needed. We could easily stop subsidies for agriculture, electric cars or building roads and bridges to nowhere right now, without fearing a recession. Most "spending" is in fact transfer payments, which even Keynesian economics recognizes are not very simulative, not the mythical (and curiously carbon-intensive) roads and bridges, and most of that goes to people who are relatively well off..."

    What percentage of roads or bridges are to nowhere, honestly? Krugman and most Keynesian economists are against inefficient agriculture subsidies. Electric cars? Are you going to argue against the externalities from not insuring against catastrophic global warming risk? (or funding some of the worst and most harmful authoritarian regimes in the world).

    And, if most "spending" is in-fact transfer payments (aside from the fact that millions of hardworking middle-class families with children face ruin, no medical care, or homelessness, without social insurance in a very risky world – try to imagine if that was your family, if you didn't have a high paying job for life), then why don't you come out for far more public investment? This is a big question. Long term growth is almost all about scientific advance, and the high end infrastructure and education so crucial to scientific advancement. Why aren't you calling for universal pre-school, like Heckman? For big increases in smart infrastructure? In basic science. Universal free bachelor's degree (or valid technical training). Studies show most students today working at least 20 hours per week which going to college full-time, about a quarter work 40+. How much would that have hurt your learning if you had to do that? Here's one of my favorite Paul Romer quotes:

    As just one example, recall that the increasing returns to scale that is implied by nonrivalry leads to the failure of Adam Smith’s famous invisible hand result. The institutions of complete property rights and perfect competition that work so well in a world consisting solely of rival goods no longer deliver the optimal allocation of resources in a world containing ideas.

    At: http://www.stanford.edu/~chadj/Kaldor200.pdf

    Why aren't you coming out more for public investment, instead of just against public transfers?

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    Replies
    1. RICHARD,

      I HAVE READ A POST, I THINK IT WAS HERE IN THIS BLOG, WHERE IT IS SAID THAT THE PROBLEM IS NOT REALY ABOUT STIMULUS (IN THE POST THE GUY EVEN JOKED THAT BUILDING BRIDGES IS A NEW LIBERAL PRIORITY). THE REAL PROBLEM IS THAT THIS SO CALLED STIMULUS IS GOING TO THE WRONG DIRECTION AND IS NOT ACHIEVING ITS TARGET.

      Delete
  16. Richard: I think people on the right are worried that once you start down that road, you end up in the Soviet Union. They may have a point, but the same slippery slope argument can be made about literally anything

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  17. Noah has some opinions here:

    http://noahpinionblog.blogspot.com/2012/03/cochrane-blasts-austerity-and-stimulus.html

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  18. It's amazing that people still argue about the chief causes of these countries problems. Whilst structural reform is no doubt a good idea let's not kid ourselves about why these countries are in such a mess: there has been an almighty banking crisis which for these countries is exacerbated by the fact they are locked into a currency union that denies them crucial firefighting tools.

    Since the crisis hit there have been huge outflows of capital from the periphery (thanks to liberalised capital markets) as they have undergone sustained attack by the markets. The markets attack them because they are weak or perceived to be weak: It doesnt matter which because the markets know that with a currency union of countries without a truly independent central bank that can act as a lender of last resort, ultimately if they persist with their attacks they will be successful.

    I agree with the first 2 comments that a policy mix of stimulus and structural reform is advisable but in my opinion it's much too late to save these countries. They need to come out of the Euro, devalue and rebuild.

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