UK and US should take chance to push growth

At the Toronto summit of the Group of 20 leading economies in June 2010, high-income countries turned to fiscal austerity. The emerging sovereign debt crises in Ireland, Greece and Portugal were one of the reasons for this. Policymakers were terrified by the risk that their countries would turn into Greece.

The G20 communique was specific: “Advanced economies have committed to fiscal plans that will at least halve deficits by 2013 and stabilise or reduce government debt-to-GDP ratios by 2016.”

Was this both necessary and wise? No.

The euro zone was at the centre of the sovereign debt crisis frightening the world. Rapid fiscal tightening was judged essential for troubled governments. That view, in turn, persuaded those not yet subject to market pressure to tighten pre-emptively. That was very much the position of the UK’s coalition government.

The idea that being Greece was around the corner gained traction in the US too, notably among Republicans. Today’s battle over sequestration is partly a product of that concern.

ECB failures

A leading and, in my view, persuasive proponent of a contrary view is the Belgian economist, Paul de Grauwe, now at the London School of Economics. He has argued that euro zone countries’ debt crises resulted from European Central Bank policy failures. Because of its refusal to act as lender of last resort to governments, they suffered liquidity risk – borrowing costs rose because buyers of bonds lacked confidence they would be able to resell easily at all times. That, not insolvency, was the immediate peril.

Today, argues de Grauwe in a co-authored paper, the decision in principle of the ECB to buy up the debt of governments in trouble, through the so-called “outright monetary transactions” (OMT), allows one to test his hypothesis. He notes that the chief determinant of the reduction in spreads over German bunds since the second quarter of 2012, when OMT was announced, was the initial spread. In brief, “the decline in the spreads was strongest in the countries where the fear factor had been the strongest”.

What role did the fundamentals play? After all, nobody doubts that some countries, notably Greece, had and have a dreadful fiscal position. One such fundamental is the change in the ratio of debt to gross domestic product.

The paper makes three important observations. First, the ratio of debt to GDP increased in all countries even after the ECB announcement. Second, the change in this ratio turned out to be a poor predictor of declines in spreads. Finally, the spreads determined the austerity borne by countries. Paul Krugman of the New York Times adds an extra point: austerity was costly for the afflicted economies: the greater the tightening between 2009 and 2012, according to the International Monetary Fund, the bigger the fall in output.

By adopting OMT earlier, the ECB could have prevented the panic that drove the spreads that justified the austerity. It did not do so. Tens of millions of people are suffering unnecessary hardship. It is tragic.

Nevertheless, I can see two arguments for the ECB’s behaviour. The first is that help could only follow a demonstrated willingness to embrace austerity. Second, as the latest European Economic Advisory Group report rightly notes, the real problems have been destabilising capital flows, external imbalances and worsening competitiveness, not fiscal deficits.