Simon Wren-Lewis: DeLong-Summers Smackdown Watch: Austerity May Be Self-Defeating Even When Treasury Interest Rates Contain a Large Risk Premium
The current draft of "Fiscal Policy in a Depressed Economy":
[D]iscretionary fiscal policy in a depressed economy is most likely to fail its benefit-cost test if there is a wedge between the real Treasury borrowing rate (that determines the burden of the debt) and the social rate of time discount (that determines at what multiple future benefits and costs are capitalized).... A government that must borrow at the terms of a Greece or a Spain—or that fears that even marginal additional borrowing will produce a market reaction that will force it to borrow on the terms of a Greece or a Spain—will find the arithmetic of expansionary fiscal policy unpleasant indeed...
Simon Wren-Lewis smacks us down:
mainly macro: The Fruits of European Austerity: In an earlier post I argued that austerity in Eurozone countries like Ireland was not necessarily self defeating, if those governments were put in a position where they had to convince markets that they would not default.... [But] DeLong and Summers... [is] not the key issue....
Spain first.... [W]hen it comes to default risk in Eurozone countries, it may be more appropriate to look at the consolidated balance sheet of the government and banking sectors. A good proportion of the banking sector in countries like Spain is fragile because too much was lent before the recession. Because this proportion is large, these banks will be seen as too important to fail, and so the government will bail them out at some point, which is why the consolidated balance sheet becomes relevant.... If this is the case... looking at just the government, the impact of cutting spending on the deficit is very unlikely to be offset by lower taxes or higher transfers generated by lower output.... However, when lower output generates falls in asset prices and adds to personal or company liquidations, this could make a big difference.... That is one reason why austerity might be self defeating.
The second, which is happening in Greece right now, is that austerity is pushed so far that it loses democratic support. Demonstrations of austerity designed to show that the government will not default become pointless if those demonstrations mean the government falls to others who would default. And allowing output to remain depressed as a consequence of austerity clearly does undermine the political centre....
[T]he moral of this story is that creditors have to be very careful when inflicting austerity on debtors. In some cases, like Ireland, they may succeed in doing so on quite painful terms, and the debts will be repaid. In other cases, they may go too far, with highly damaging results for everyone. It has happened before in Europe, as Miller and Skidelsky remind us.
