He begins with the usual narrative from the "guardians of austerity", that sounds good, but it is not true:
- When some economists spoke of panic and confidence crises, they meant their own. Bailout funds and Eurobonds were an invitation to moral hazard. Throwing money at the problem turned out to be unnecessary. Europe’s problem was an old-fashioned one: too much spending. Now that technocrats have replaced populists in the eurozone’s Mediterranean members, sustained fiscal austerity will get us out of trouble.
- A country with a large public debt (say, more than 50% of GDP) is safe if everyone thinks the debt will be serviced; the interest rate charged on the debt remains low, and the country can indeed pay it, following a path of virtuous self-fulfilling expectations. But everything changes if markets come to doubt that the debt will be repaid; then the interest rate demanded by investors can rise so high that the country cannot pay. Default follows, owing to a vicious self-fulfilling panic.
- If European leaders had deployed a rescue fund endowed with overwhelming financial force in early 2010, Europe and the world would have been spared two years of agony. In the end, it was the ECB that stepped into the breach, drowning eurozone banks with liquidity to make sure that they purchased every government bond that moved – and then some.
- So the speculative attacks were stopped, at least temporarily (though interest-rate spreads in Spain and elsewhere have begun to creep up again). That was the first task. But there remains a second one, and here the guardians of austerity are getting it wrong again. ... To prevent a repeat of the last two years, they must reduce their public debt dramatically. ... The question is how. In Greece, debt forgiveness was the only answer. Some has been accomplished; more will be necessary down the road. For the rest of Europe, massive upfront austerity of the kind advocated by German Chancellor Angela Merkel – and supported by the prevailing German orthodoxy – will not do the trick.
- Up-front gradualism must be the name of the game. And adjustment must be wedded to a growth strategy. Revenue will grow consistently only if the tax base – that is, the economy – grows. And that growth requires higher public investment in infrastructure and human capital. The guardians of orthodoxy are not about to put forward such a growth strategy. Will anyone else?
Brad DeLong and Lawrence Summers have made recently a communication to Brookings Institute that gives a strong theoretical support to growth policies in depressed situations. In their draft paper ("Fiscal policy in a depressed economy", available here) they conclude that
- policies of deficit reduction in the presence of substantial output shortfalls will have adverse impacts in both the short and long run, and may even exacerbate creditworthiness problems.
- We argue that, while the conventional wisdom rejecting discretionary fiscal policy is appropriate in normal times, discretionary fiscal policy where there is room to pursue it has a major role to play in the context of severe downturns that take place in the aftermath of financial crises.
- A combination of low real U.S. Treasury borrowing rates, positive fiscal multiplier effects, and modest hysteresis effects is sufficient to render fiscal expansion self-financing.
(Update: see Martin Wolf post in his FT blog, about DeLong and Summers paper, 20 april 2012:
- This is an important paper. It challenges complacent “do-nothingism” of policymakers, let alone the “austerians” who dominate policy almost everywhere. Policy-makers have allowed a huge financial crisis to impose a permanent blight on economies, with devastating social effects.)