Too early to sound the alarm

Manfred Neumann 17 April 2012



Debt finance of public consumption has clearly gone too far in several countries. Too far in the sense that it has reached if not exceeded the borderline of sustainability. Have austerity measures meanwhile gone too far, too?

I don’t think this is generally the case. Let’s take GDP growth as a rough indicator. According to the IMF the global economy is likely to grow this year by 3.3%. The forecast is down by half a percentage point, hardly an alarming number. The Eurozone, by contrast, is at the borderline to a mild recession; output might shrink by half a percentage point this year.

But let’s look behind the curtain of the average. The Eurozone weak forecast is dominated by the negative growth prospects of the south, where the two larger countries, Italy and Spain, needed cuts in public consumption. The outlook for Greece and Portugal is worse but they have small weight. In sum, if we take output growth as indicator, there is some evidence that austerity may have gone too far in one or the other member country of the Eurozone. On the other hand, if we look at public consumption and public deficits, it is not clear at all whether enough has been achieved.

And what do we mean by “gone too far”? Did anyone expect that short-run growth would go unaffected when countries switch from fiscal expansion to austerity? Even politicians know that there is this price to pay though they might have no idea how large the fiscal multiplier might become. Withdrawing from a drug ‘in one stroke’ can be a potentially dangerous venture. But trying to do it in many small doses makes it most likely to get no lasting results. Moreover, the longer the austerity process takes, the weaker public endorsement will become. A serious problem in this respect is that politicians are often tempted to minimise the austerity measures as well as delay and renege on promises of structural reform.

In sum, it seems too early to sound the alarm.

But let’s assume that the authorities of a high-risk country believe that the country can no longer bear the price of austerity? What can they do? Three options spring to mind:

  • A first option is simply to reverse the fiscal stance.

It seems to be futile to do so, however, as it is likely to immediately unleash a confidence crisis, pushing up the sovereign risk-premium. In brief, it would not only mean to forgo harvesting the fruits of the past austerity efforts but to fall deeper into debt unsustainability.

  • A second option is to check the austerity composition.

As emphasised by Alesina and Giavazzi (2012) the type of fiscal adjustment chosen makes a tremendous difference. Spending-based adjustments are to be preferred to tax-based adjustments. Cutting into spending is able to generate the expectation of lasting budget consolidation and of lower future taxation, hence higher permanent income. Unfortunately, once an ill-designed adjustment programme is under way, attempts at restructuring may become politically very difficult if not impossible.

  • A third option is to exit the euro.

To talk about this option is widely considered politically incorrect. I do understand this insofar as there are still some freaks around who are obsessed with the idea of fractionalising or undoing the euro. Extremism should be disregarded, yet economists must not shy away from doing the analysis of exit.

The exit option has many pros and cons that cannot be taken up here. The main reason to mention the exit option clearly is the problem of insufficient relative price adjustment. Does it make sense forcing Greece into a decade of austerity and slump in order to achieve a sufficiently low wage level? Wouldn’t currency depreciation be a much more effective strategy to achieve price competitiveness in one stroke and turn the country to recovery?

The inflation option

Finally, there is the infamous option of inflation. It is tempting for any government to take recourse to monetary policy. Collecting the inflation tax is the unpleasant solution of the monetarist arithmetic of government finance (Sargent and Wallace 1976). Many governments have chosen this solution time and again when their budget policies got out of hand.

In the south of Europe the inflation tax was considered a normal source of government finance before the foundation of the Eurozone. To be sure a country like the UK that has kept its own currency may choose to inflate its sovereign debt away. But this is no admissible solution for the member states of the Eurozone. They have signed a Treaty that rules out using inflation for government finance. They have tied their hands and must honour the commitment, except if they are prepared to exit the Eurozone. The commitment must equally well be honoured by the jointly owned ECB. The Bank has been provided formally with the status of independence from governments to fulfil the mandate of maintaining price stability. The independence status loses justification should the ECB not deliver the product but concentrate on nursing careless investors and a few high-risk governments.

The ECB should not be lender of last resort to governments

The ECB’s excessive swinging round to massive intervention in selected sovereign markets and the unprecedented blowing-up of long-term refinancing operations can be taken as signals that the ECB erroneously believes it must adopt the function of lender of last resort to governments (Wyplosz 2011). This makes little sense.

  • Since the early 19th century central banks’ last-resort lending serves to provide liquidity to solvent banks when market participants hold off temporarily for lack of sufficient information about solvency.
  • The solvency of countries is much easier to monitor.

A country that is known to be fundamentally solvent will never become illiquid but always be able to borrow at short notice.

In conclusion, the notion that a solvent country needs the ECB to bridge a situation of illiquidity is a non-flyer. The notion serves to hide that the ECB’s securities market programme can be misused to redistribute resources between member countries. That constitutes a serious problem. After all, redistribution is a matter for elected politicians, not for appointed central bankers.


Alesina, A, and F Giavazzi (2012), “The austerity question: ‘How’ is as important as ‘how much”,, April.

Sargent, T J, and N Wallace (1994), “ Some Unpleasant Monetarist Arithmetic”, in The Theory of Inflation, 291–307.

Wyplosz, C (2011), “An Open Letter to Dr Jens Weidmann”,, 18 November.



Topics:  EU policies Macroeconomic policy

Tags:  eurozone, fiscal policy, austerity

Research Professor, Research Centre, Deutsche Bundesbank


CEPR Policy Research