Is austerity self-defeating? Of course it is

Posted by Jonathan Portes on 10 April 2012

The main argument of Giancarlo Corsetti’s article is that, in the short term, both fiscal austerity and “sovereign” risk have a contractionary impact in the short-term; the optimal policy for countries which require  fiscal adjustment  is hence to steer between the Scylla of excessive short-term fiscal contraction, which will reduce demand and output; and the Charybdis of a loss of market confidence in government debt, with knock-on impacts on risk premia for private sector borrowing and hence will also damage the real economy. Not a comfortable situation.

At one level this is obvious.  At another level, however, it is misleading, and, if taken seriously by policymakers, potentially damaging, for three reasons. First, it fails to distinguish between Eurozone countries and those that have monetary sovereignty, for which these tradeoffs, at least in this form, simply don’t apply. Second, it fails, for the former, to correctly identify the source of sovereign risk, and hence risks prescribing policies that will be ineffective if not damaging.  And third, it treats individual countries as if they were making independent policy decisions –when, of course, this crisis is a Eurozone crisis and needs to be addressed as such.

First, the paper underlying Corsetti’s article is simply irrelevant to the current European policy debate, which leads to an odd omission in his analysis. The paper examines the macroeconomic implications of sovereign risk in the case of government borrowing in a closed economy (so, by definition, borrowing is in the government’s own currency) with an independent central bank.

But we know what the macroeconomic impacts of “sovereign risk” – in the sense of credit default risk- are in this case. None, because there isn’t any such risk.  This is not just true for the “reserve currency” US, but also for the high-deficit UK (in fact, figure 2 of Corsetti’s  paper shows this pretty clearly).  Long-term interest rates in the UK have moved in tandem with equity prices, suggesting (as theory would suggest) that they are driven by expectations of future short rates, rather than spurious concerns about solvency.  Foreign investors in UK debt do of course face exchange rate risk, but this is very different and has very different economic impacts.

The rating agencies may continue to embarrass themselves by demonstrating that they literally do not know what they are talking about when they rate countries like the US, Japan and the UK, but there is no need for economists to do so.  For such countries, fiscal policy should be set with reference to what is economically sensible – that is, balancing the short-term impact on demand and output with the need for fiscal sustainability over the medium to long term – without reference to imaginary demons.  As set out here, the case for rapid consolidation in the UK and US is exceptionally weak.   

By contrast, as shown by Paul de Grauwe here (see also Wren-Lewis here), sovereign risk can exist for countries that are part of a monetary union and borrow in the currency of that union, as for the Eurozone; so here there are real risks. Corsetti’s comparison of Italy and the UK, in the context of a discussion of “sovereign risk”, is therefore simply a category mistake.

But, even when applied to Eurozone countries, Corsetti’s analysis is again potentially misleading, because his argument assumes implicitly that the dominant factor in driving market perceptions of sovereign risk is short-term fiscal policy.  In fact, however, as de Grauwe shows, sovereign risk (for countries like Spain and Italy – Greece, which was clearly insolvent long ago, is different) is driven by the potential existence of multiple equilibria in debt markets, which in turn means that a liquidity problem has the potential to become a solvency crisis.  In the short term, the obvious and direct way to deal with this issue is to provide explicit or implicit guarantees against such a possibility.

Empirically, it is indeed obvious that this is what has been driving short-term developments; the near disaster in Eurozone debt markets at the end of last year, and the partial recovery in the first few months of this, have little or nothing to do with short-term movements in the fiscal position or plans of the Spanish and Italian governments, and everything to do with a change of key personnel and regime at the European Central Bank.

What does this imply for fiscal policy? Clearly long-run solvency is also essential.   But, in Spain and Italy, trying to hit arbitrary short-run deficit targets, as proposed by the European Commission, is likely if anything to be counterproductive to the objective of long-run sustainability.   Spain’s long-term fiscal position, for example, is relatively strong; what it needs to ensure that remains the case is decent levels of economic growth, and what it needs for that is structural reform, especially labour market reform. Both politically and economically, such reforms will be both less painful and more effective if fiscal consolidation is much slower, as I argue here.   

These arguments on timing hold good even if multipliers and hysteresis effects are relatively small; if such effects are large – and there is every reason to believe that in European labour markets hysteresis effects are of profound macroeconomic importance – then they are even more compelling, as Brad Delong argues here.  At least in the UK, the evidence for unemployment scarring is very strong, as shown in the background research to this report on youth unemployment.

This in turn leads on to the third, and most important, lacuna in Corsetti’s article. As set out above, this is not a crisis of sovereign debt in a few countries, and to imply that, for some countries, the main policy requirement is short-term fiscal tightening in those countries, is dangerous, for the countries in question and the euro area as a whole.   As set out in Shambaugh (2012), the euro area faces three interlocking crises, and it is euro area level responses that are required:

“Bailouts of banks have contributed to the sovereign debt problems, but banks are also at risk due to their holdings of sovereign bonds.  Weak growth contributes to the potential insolvency of the sovereigns, but also, the austerity inspired by the debt crisis is constraining growth.  Finally, a weakened banking sector holds back growth while a weak economy undermines the banks.”

The policy implications for the Eurozone as a whole – loose monetary policy, action to recapitalise and resolve banks, and fiscal policy coordination, including looser fiscal policy in less vulnerable countries – are obvious, and have been so for some time; even David Cameron, who continues to pursue damaging and misguided fiscal policies domestically, set them out clearly in an excellent speech at Davos earlier this year.    In particular, of course, the DeLong and Summers analysis strengthens the case for coordinated European fiscal policy action; while multipliers in any one European country (including the UK) are likely to be much smaller than that for the US, the multiplier for Europe as a whole might be expected (since the EU is roughly as open an economy as the US) to be approximately the same.    

Consequently, the question posed by this Vox debate – “Is austerity self-defeating”? – more or less answers itself, when looked at a European level.  Of course it is. The much more difficult task for European economists is to convince European policymakers that this is not the question they should be asking at all.


Commission on Youth Unemployment (2012). “Youth Unemployment: the crisis we cannot afford”, ACEVO.
Corsetti, G (2012), “Has austerity gone too far? A new Vox Debate”,, 2 April.
Corsetti, Giancarlo, Keith Kuester, André Meier and Gernot Müller (2012), "Sovereign risk, fiscal policy and macroeconomic stability", IMF Working paper 12/33.
De Grauwe, Paul (2011), “Managing a fragile eurozone”,
DeLong, Bradford and Lawrence H. Summers (2012). “Fiscal Policy in a Depressed Economy”, paper presented at the Spring 2012 Brookings Panel.
Portes, J (2012).  “Long-term interest rates and confidence”, blogpost.
Shambaugh, J, “The euro’s three crises”, paper presented at the Spring 2012 Brookings Panel.
Wren-Lewis, S (2011). “The case against austerity today”, Institute for Public Policy Research.


Jonathan Portes
Director, NIESR