In a stunning rebuke to the conventional wisdom, austerity has come to dominate economic policymaking in the last three years. Traditionally, governments resorted to Keynesian measures to prime the pumps during recessions and compensate for falling demand. During the most recent economic downturn, governments have embraced austerity instead, compounding the contractionary pressures.
This new logic has been justified by the work of two Harvard University economists, Ms. Carmen Reinhart and Mr. Kenneth Rogoff, who studied the historical record and concluded that “traditional debt management issues should be at the forefront of public policy concerns.”
Their extensive research revealed that countries with a debt-to-GDP ratio above 90 percent have had a negative growth rate — minus 0.1 percent — on average, since 1946. As the United States and countries in Europe approached that threshold, policymakers feared that the stimulus measures that a traditional Keynesian response demanded would push them into a prolonged and even more damaging slump.
This analysis, more than any other, has been responsible for the vogue for austerity that has dominated economic decision making in recent years. It provided the intellectual bulwark for policies that have driven unemployment in Greece and Spain to record highs and pushed the public across Southern Europe to the breaking point.
Unfortunately, it is also wrong. A team of graduate students at the University of Massachusetts Amherst looked hard at the data and discovered it did not support the conclusions of Ms. Reinhart and Mr. Rogoff. They concluded that the two economists were guilty of excluding data, spreadsheet errors and strange weightings of certain countries.
In the original data sets, figures from Australia, Canada and New Zealand were excluded; once they were added, the average growth rate jumped to 2.2 percent, rather than the minus 0.1 percent that gathered headlines. Plainly the revisions substantially undermined the case for austerity.
Ms. Reinhart and Mr. Rogoff conceded a “coding” error in their spreadsheet, but refused to back off their main point — there is a correlation between debt and slower growth. They point to analysis by the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development OECD) that backs their conclusions.
The problem here is twofold: First, correlation most certainly exists, but policy was based on causality; moreover it is not clear which way the causality runs. It could be that the slow growth produces debt, not the other way around. Second, the degree to which growth slows is critical.
Growth of both 2.2 percent and minus 0.1 percent is lower than the average growth rate of about 3.5 percent registered when the debt-to-GDP ratio is at under 90 percent. But there is a huge difference between them. Officials at the IMF were rethinking austerity even before the criticisms of the Reinhart and Rogoff study surfaced. With economies slowing throughout the eurozone, they are less committed to the deep cuts that have dominated government budgets in Europe.
While conceding the need for balanced budgets, in meetings last month, IMF Managing Director Christine Lagarde declared: “We need growth, first and foremost. … Should growth abate … there should be consideration for adjusting the pace” of fiscal consolidation.
Ms. Lagarde’s logic is underpinned by skyrocketing unemployment rates. In Spain, unemployment is now 27.2 percent of the workforce, or more than 6 million people, the highest since 1976. The IMF anticipates a 1.6 percent contraction in the economy this year.
In Greece, the seasonally adjusted unemployment rate spiked to 27.2 percent; for Greeks age 15 to 24, the figure is 59.3 percent. The entire economy shrank 6.4 percent last year and is forecast to contract another 4.4 percent in 2013
Europe’s largest economies are not looking to do much better. Germany is set to grow just 0.6 percent. France, the No. 2 EU economy, is forecast to shrink 0.1 percent, after no growth in 2012.
The Italian economy is anticipated to shrink by 1.5 percent. The dismal economic results despite or because of austerity are creating virtually ungovernable countries, as is the case in Italy. But France, Greece and Spain could also erupt.
Still, many key decision makers refuse to bend. Britain remains wedded to its austerity budget even though it is, in the opinion of IMF chief economist Olivier Blanchard, “playing with fire.”
Top officials at the European Central Bank are skeptical about the merits of relaxing austerity, arguing that markets expect restructuring and the failure to follow through will push up interest rates and make it harder still to service debt.
There is merit to the claim that piling on debt without a commitment to restructuring will undermine long-term prospects for European economies. And it is more than ironic that the IMF is relaxing its hard line as it deals with European debt, a flexibility that was not evident when the institution was imposing reform on Asian economies in the late 1990s.
Yet the extraordinary human cost of this new mentality is threatening national political systems. Indifference to the human consequences of economic decisions will undermine political will to embrace reform — if not the governments themselves.
Austerity may well prove its own undoing.