Is austerity self-defeating? Of course it is: [We need] to distinguish between Eurozone countries and those that have monetary sovereignty… to correctly identify the source of sovereign risk… [to treat] this crisis is a Eurozone crisis and needs to be addressed as such….
[W]e 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…. 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…. 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…. But… [when] 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… 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….
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… is likely if anything to be counterproductive to the objective of long-run sustainability…. 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…. 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….
As set out in Shambaugh (2012), the euro area faces three interlocking crises, and it is euro area level responses that are required… 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….
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.