Oh dear. Reinhart and Rogoff may wish to avoid ever holidaying in Greece, Portugal, or Spain. Their seminal (and now-disproved) paper – arguing that once a country’s public debt was over 90% of their GDP, there is a strong negative relationship with the country’s economic growth – probably took up a fair amount of the Troika’s discussion time when it was deciding on the measures the peripheral countries needed to take if aid were to come their way.
Of course, Reinhart and Rogoff were not the only ones to argue that high government debt is bad for growth. Over the years, several economists have pointed out that government borrowing can crowd out private investment, and that reducing government borrowing can allow growth to resume.
But, as my colleague Robin Anderson pointed out in an earlier post, there have also been many economists that have argued that the relationship works the other way: countries are likely to have high debt-to-GDP ratios because they are having serious economic problems. Certainly, there have been many Greek, Italian, Portuguese, and Spanish policymakers arguing that introducing stimulatory measures to growth would be a more successful way to reduce debt and increase growth.
The evidence of the past three years certainly suggests that fiscal austerity is not ideal for growth. Greece has undergone severe fiscal tightening, cutting its deficit from almost 16% of GDP in 2009 to 6% of GDP in 2012. Yet, the economy has shrunk 17% over the same period and still is not expected to return to growth until at least 2014. Similarly, the Spanish deficit reduction in 2012 stands out as very large and close to the ‘efficient’ point in terms of achieving the maximum amount of deficit reduction – yet, unemployment continued to climb throughout 2012, and has now breached the 27% level. Meanwhile, the debt ratios in both countries continue to climb (excluding the Greek debt haircut of last year).
What does all this mean going forward? The ball had already started rolling before the Reinhart-Rogoff error became apparent. Arguably, French Prime Minister Francoise Hollande could be credited for the subtle change in emphasis, since he started the growth-versus-austerity argument during the elections in early 2012. Peripheral countries latched onto his argument with ferocity last year, resulting in some encouraging comments about potentially targeting structural deficits instead of cyclical deficits in the future.
But it is in the past few weeks that policymakers have dramatically changed their tune. The latest IMF World Economic Outlook, released last week, warned several European countries, including the UK, to rethink their austerity plans. IMF chief, Christine Lagarde, had previously given consistent and clear support to the UK’s aggressive fiscal austerity plans but has now changed her mind. This lady has done a U-turn.
In addition, the President of the European Commission, José Manuel Barroso, said earlier this week that, while further consolidation and reform efforts are required, such an approach had “reached its limits in many aspects.”
It is difficult to argue with this. At some point, fiscal consolidation becomes self-defeating: raise taxes too much and household income and spending fall and, in turn, tax revenues fall. That seems to be the case in Europe at the moment. Unemployment in Greece and Spain is above 25%, and in Portugal it is not far off 20%. Without some growth boosting measures, unemployment will continue to rise and it will be even more difficult to bring down debt ratios. Troika advice should now focus not on fiscal consolidation measures, but on structural reforms designed to improve flexibility in the labour markets and improve productivity – and on fiscal stimulus.
Hopefully, Reinhart and Rogoff’s blushes will accelerate the case for “growth, not austerity.”
The information in this article has been derived from sources believed to be accurate. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity.
The information in this article contains general information only on investment matters and should not be considered as a comprehensive statement on any matter and should not be relied upon as such. The general information it contains does not take account of any investor’s investment objectives, particular needs or financial situation, nor should it be relied upon in any way as a forecast or guarantee of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice.
Subject to any contrary provisions of applicable law, no company in the Principal Financial Group nor any of their employees or directors gives any warranty of reliability or accuracy nor accepts any responsibility arising in any other way (including by reason of negligence) for errors or omissions in this article.