Two Fed Governors Confirmed. No, I Do Not Know Anything About Their Views on the Appropriate Stance of Monetary Policy
Liveblogging World War II: May 18, 2012

DeLong-Summers Smackdown Watch: Simon Wren-Lewis: Is Eurozone Austerity Self Defeating?

Simon Wren-Lewis:

Is Eurozone Austerity Self Defeating: Suppose DeLong and Summers (full paper here) are right, and at the zero lower bound temporary fiscal stimulus leads to an eventual reduction in the debt to GDP ratio because of hysteresis. Does that mean that all this austerity in the Eurozone is counterproductive?…

‘Stimulus’ involves in the short term cutting government spending less (at least). Unless multipliers are implausibly large this will raise both deficits and the debt to GDP ratio in the short run (the red line). What DeLong and Summers argue is that the negative effects of austerity on output in the medium term will mean that the two paths for debt to GDP will at some point cross. In other words stimulus will at some point lead to a better outcome for the debt to GDP ratio.

For any government not having to pay a large risk premium on their debt, and not likely to encounter such a premium, this is an important argument. If true, it does indeed suggest that the rapid austerity being undertaken by countries such as the UK will eventually make their fiscal position worse. In addition, arguments that we have to follow the austerity path because the stimulus path is not credible are beside the point…. Nor does the argument that we cannot change course now make much sense. In the UK and US fiscal policy does not have to be credible, it just needs to be sensible.

In the case of Ireland and other Eurozone countries the immediate motivation for austerity is a high risk premium on government debt. What potential investors in Irish government debt are worried about is not where debt is likely to end up, but the likelihood of default before we get there. Here the credibility argument does apply.

One reason why government might default is a political inability to cut spending or raise taxes enough to get the primary budget balance into surplus. Governments can demonstrate that they do have that ability by cutting the deficit rapidly now….

The markets are, quite rightly, not very interested in what happens into the medium term, because by that time default risk under either policy has all but disappeared. So if the overwhelming priority is to reduce the risk premium on government debt, austerity makes sense….

Which brings us to Germany. In the past I and others have written as if this Hobson’s choice faced by periphery Eurozone countries could be partially relieved if only Germany would expand more rapidly. However, as I outlined here, this was not a very realistic wish…. The reason we will not see rapid expansion in Germany is because the economy is doing all right as it is. While inflation of 5% in Germany would certainly be very useful for Spain et al, it would not be in the national German interest. The only possible exception might be if the Eurozone as a whole looked like coming apart, in which case it might be in Germany’s interests to incur these costs….

Seeing the Eurozone as a single bloc, it makes sense to note that fiscal correction in this bloc is far more rapid than in the US or even the UK, and for the area as a whole that will be very damaging. If there was a Eurozone government, it should be undertaking a substantial fiscal stimulus in Germany right now. But to blame Germany for not doing this of their own accord is rather pointless….

So the only real hope is monetary policy…

I would disagree. It is in Germany's long-term interest to be a good macroeconomic steward for Europe: to be a proper Kindlebergian hegemon. The fact that Germany now has a relatively undervalued internal price level, is experiencing an export boom, and has no internal desire for more-rapid demand expansion is neither here nor there.

A country as large as Germany in the European economy needs to act like a responsible grownup. If it isn't going to be a proper hegemon, then perhaps it should divide itself into six smaller countries, let France become the single largest European economy, and let France try to do the job…