The Economic Fallacy of Austerity

Lat week saw a new meeting of the Eurogroup that puts Greece back to the top of the European agenda. The country needs debt relief if it is ever to get back on its feet again. This fact is acknowledged by the IMF. However, Eurozone finance ministers, under the leadership of Wolfgang Schäuble, have so far been reluctant to speak or maybe even see the truth in this matter. They still insist on austerity policy without debt relief. A recent economic study shows how dangerously wrong this is. By Oskar Achten and Korbinian Rüger

German finance minister Wolfgang Schäuble and the IMF’s managing director Christine Lagarde.

With the recent landslide victory of Emmanuel Macron’s party “La République En Marche” in France comes a renewed sense of a unified Europe as Brexit negotiations are commencing. Yet to maintain this positive trend, the economic struggles of some European countries have to be resolved. This holds especially true for the ever-ailing Greek economy. Last Thursday the latest tranche of financial aid was approved but negotiations over cutting the debt were once again halted by German minister of finance Wolfgang Schäuble.

The Eurogroup’s meeting revealed the underlying conflict that makes real progress seemingly impossible for Greece. The German government, represented by Schäuble, insists on the IMF’s participation in the bailout and in turn the IMF made its contribution contingent on debt relief for Greece. Last week’s agreement reflects these opposing views and makes debt relief merely a future option. Moreover is the Greek economy subject to strict austerity measures for decades to come. As countless before, this agreement does little more than avoid immediate bankruptcy and fails to present a viable possibility for recovery.

2017 is not an ordinary year in the German political calendar, but an election year. Since the discussion over the Greek bailout was always highly political, even within Germany, Schäuble is very concerned about the consequences of these negotiations for the general election to be held in September. Out of solidarity with German taxpayers, the government has always been keen to see German involvement in bailouts tied to severe austerity policies for the Greek government. Not least to limit the rise of the AfD, which had originally been founded to give a political voice to critics of the German and European bailouts of failing economies during the Eurocrisis.

Before recent negotiations were held there were calls inside and outside Germany for debt relief to give the Greek economy room to breathe. Both France’s recently elected president Macron and German minister for foreign affairs Sigmar Gabriel made similar comments, and they are right to do so. In the end, the discussion concerns the sensibility of austerity to recover an economy in dire straits. According to proponents of austerity, Schäuble being the most prominent one, struggling economies have to massively reduce their spending in order to qualify for credit. However, a recent economic study from the US shows that Schäuble finds himself on the losing side of this debate.

The study shows how imposed austerity cuts have undermined Greece’s chance of economic recovery. Relying on data from 29 countries, economists from the Universities of Michigan and Lausanne researched the impact of austerity measures on economic development after the “great recession” of 2008 and 2009. Their aim was to find an explanation for the huge variation in recovery rates within Europe and across the globe. The USA, for example, recovered much quicker than many European economies, especially Greece, for which real recovery never began until this day.

From their empirical investigation the authors were able to conclude that Greece’s drastic reduction in government spending (i.e. austerity) was responsible for this to a much higher degree than so far had been assumed. They show that on average, for every €1 reduction in public spending GDP falls by €2. Since the shortfall between Greece’s projected public expenditure and the actual expenditure after the crisis was higher than anywhere else, this explains the country’s poor performance. The study also investigates a counterfactual scenario without austerity cuts. In this scenario the average GDP of the five countries hit the hardest by the crisis (Greece, Italy, Ireland, Spain, Portugal) would have, on average, reached near pre-crisis level by the year 2014, compared to an 18% shortfall in reality at that time.

One of the most surprising takeaways from the investigation is the fact that austerity measures didn’t have any positive effects on the debt to GDP ratios of the concerned economies. After all, this had been the main goal of the imposed cuts. Instead of reducing the ratio by 20%, as Greek creditors had hoped, it actually increased by 20%. According to the study, this can be explained by negative multiplier effects induced by reduced public spending. Had those cuts never occurred, the debt ratio would not have risen as it has. This suggests that the austerity measures were in fact counterproductive to reaching the goal of reducing government debt. European austerity policies in the aftermath of the recession have been actively harmful for the Greek economy. They have induced economic effects directly opposing those intended by those policies. Instead of reducing debt to GDP ratio to a healthy level, they have actually done the opposite.

It is high time to officially acknowledge these realities in the German finance ministry, but also act accordingly. The IMF is exactly right to demand debt relief before contributing to more loans. To oppose this position is an economic absurdity. To oppose it on grounds of pre-election political maneuvering also is dishonest to voters. The European project will never succeed without fiscal transfers from richer to poorer regions of the Union. If the Eurozone is to survive, debt relief for Greece must be among those transfers.

Oskar Achten currently is research assistant at the ifo-Institute in Munich. He holds degrees in Economics and Mathematics from the LMU Munich and the Technical University of Munich.

Korbinian Rüger is member of the PDU board and is studying for a PhD in Philosophy at the University of Oxford. He holds degrees in Economics and Philosophy from the London School Economics and the University of Bayreuth.


Image: “2013 World Bank / IMF Spring Meetings. International Monetary Fund Managing Director Christine Lagarde (R) speaks the German Finance Minister Wolfgang Schäuble (L). Photo: Simone D. McCourtie / World Bank”. Published under Creative Commons License 2.0.

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