The sovereign debt crisis has already been discussed in Europe for quite some time, at least since 2009. Radically restricting government spending—austerity—is seen as the only solution for regaining the trust of the markets. Such a method (or “cure”) is a windfall for the ideological circles in Europe and North America that have been talking since the 1970s about the inevitability of restricting state expenditure and cutting back on “welfare state” policies (which has been difficult to do in democratic conditions).
Mark Blyth, a Professor of political science at Brown University, claims in this book that mindless austerity may not be the best method for overcoming the eurozone crisis. Blyth presents two closely connected arguments based on the results of large-scale econometric analyses.
First, cutting a state’s running costs and balancing state budgets is neither the right nor the fair solution in a time of crisis since it is not the Leviathan-like governments strangling the private sector that are responsible for the crisis; it is the banking sector. Second, austerity does not work as a macroeconomic policy for restoring the growth of the eurozone—a familiar Keynesian argument, especially for readers of Paul Krugman’s blog in The New York Times—and it is difficult to adapt the policy to democratic governing principles, if it is to be implemented over a longer period of time.
The true roots of the crisis are in the private sector, and more specifically in banking. According to this view, adopting the euro made it favourable for banks to make excessive investments in the states on the margins of the eurozone because normal risk factors were ignored. Blyth shows that adopting the euro allowed for a significant reduction in the risk levels of periphery states’ government bonds by the late 1990s. The figure below shows that the reliability of PIGS (Portugal, Ireland, Greece and Spain) government bonds appeared to increase until there was no difference between investing in German or Greek government bonds.1
This high level of trust, artificially created by the common currency, led the banks of wealthy states (primarily German and French private banks) to invest imprudently in bonds issued by the Greek government and banks, and those of other regions. Loan interest rates levelled out when the euro was adopted, which meant that the rates were noticeably lower for the PIGS states compared to the past. This directed cheap money to private consumption, and created, for example, booms in real estate, and enabled some national governments to increase public spending to an ever greater extent.
In 2008, this house of cards began to collapse—the flow of cheap money to the PIGS states came to a sudden halt after the financial crisis that started in the US. All investors wanted to be rid of the government bonds of peripheral states, and their interest rates (loan costs) rocketed. It became less believable that these loans would be repaid.
Blyth shows that it was cheap money—and the fact that it ran out abruptly—that primarily paved the way for the crisis, not uncontrollable public-sector spending (although Greece is an exception). The level of state debt in Ireland, Portugal and, to a lesser extent, Spain, started to rise dangerously only in 2008 and the governments reacted to the financial crisis by bailing out banks, and followed this up with austerity policies. The debt crisis in Ireland and Spain was mainly caused by bank bailouts—not public-sector spending in the period leading up to this—and this led to a rapid increase of the debt burden and culminated in the bailout packages backed by the money of eurozone taxpayers. In essence, the state took on the private sector’s debts (including the investments of foreign banks).
Blyth admits that Greece was indeed an exception in all this because a special “Greek salad” had been thrown together by that time. The combination of public spending, falsifying the size of the national deficit and corruption was extreme compared to the other crisis-afflicted states. There is no doubt that successive Greek governments had spent too much money ineffectively prior to 2008—and that cheap loans provided them with the opportunity to do this. However, this does not mean that the Greek state’s profligate spending or the “innate laziness” of its people was the systematic cause of the crisis in the eurozone. It was the euro itself.
Austerity followed when there was no cheap money left. When governments withdrew their money from the economy this exacerbated the reduction in GDP and led to debts making up a bigger proportion of GDP in all the PIGS states. Blyth disproves the claim that state incentive packages were the main factors in increasing the debt burden. Economic incentives in the main industrialised countries caused the debt burden to increase by only 12%.2 The main causes for the increasing debts were bank bailouts combined with the impact of austerity policies.
How do we evaluate the long-term impact of measures—tax increases and restricting public spending—implemented by the so-called big three (the European Commission, the European Central Bank and the IMF) on the restoration of economic growth? Based on macroeconomic research on the period between the Great Depression and the current eurozone crisis, Blyth shows that long-term austerity cannot restore growth as quickly as, for example, currency devaluation or the Keynesian policy of pumping money into the economy to increase total national demand.3 On the contrary, austerity policies have neither reduced state debt nor increased the confidence of investors (market reliability).
But doesn’t the outstanding recovery of Estonia and some other countries like Bulgaria, Romania and Latvia—achieved through budget discipline and deflationary policies—illustrate the success of austerity? Not really, says Blyth. Special conditions in the Central and Eastern European states—e.g. the proximity of the export markets of Germany and Scandinavia that recovered quickly, and the fact that the Baltic States were able to make their unemployment the problem of the Nordic States owing to immigration—made internal devaluation possible in these states, unlike the PIGS states. This culminated in a significant reduction in the standard of living and massive emigration. Ringa Raudla and Rainer Kattel have shown that Estonia’s austerity policies could have been made politically possible by the path of dependence that started from coping with the crisis in the 1990s. The lack of prior experience in implementing Keynesian policies made it cognitively difficult for both politicians and government officials to start using an alternative economic policy.4
Blyth compares the eurozone’s handling of the crisis with the classical gold standard that was abolished in the 1930s during the Great Depression. The gold standard was a system created during the first wave of globalisation in the 19th century to guarantee the stability and convertibility of national currencies by basing their value on a fixed quantity of gold. Deflation and austerity were mechanisms for solving crises during the time of the gold standard—both prices and wages would decrease during economic recession. All types of state measure (e.g. devaluation) for increasing demand were impossible.
The mechanism of coping with the crisis in the eurozone is similar to that of the gold standard, i.e. very deflationary. For states that lost their own currency and independent fiscal policies by accepting the EU’s budget criteria, the only option is through deflation by reducing wages and prices. However, in a crisis, this type of policy creates high unemployment and loss of welfare for the states trying to cope, and cannot therefore be applied in a modern democratic society. Austerity also increases financial inequality since it is the middle class and the poor who lose the most from reducing public services and cutting back on the welfare state.
The political project of the European Union has undoubtedly been a success story. However, the economic and debt crisis cast a shadow over this success. Europe has been in a deep deflationary crisis for seven years and there seems to be no end in sight. And it was initially caused by the banking sector and the euro, not public spending.
For these reasons, it would be beneficial to give the Greeks a little more breathing space to repay their debts. The IMF, whose assistance packages for developing countries have traditionally been linked to restricting public spending, has recently also been supporting the restructuring of Greece’s debts and granting payment extensions.5 The reason for this is that growth may be restored in the meantime, which would make the repayment of debts easier in the future.
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1 Figure taken from Mark Blyth, Austerity: The History of a Dangerous Idea, Oxford University Press, 2013.
2 , “Navigating the Challenges Ahead”, Fiscal Monitor Series, IMF World Economic and Financial Surveys, 14 May 2010. https://www.imf.org/external/pubs/ft/fm/2010/fm1001.pdf 3 See, for example, Nicoletta Batini, Giovanni Gallegari and Giovanni Melina, “Successful Austerity in the United States, Europe and Japan”, IMF Working Paper WP/12/190, 2012. http://www.imf.org/external/pubs/ft/wp/2012/wp12190.pdf 4 Ringa Raudla and Rainer Kattel, “Why Did Estonia Choose Fiscal Retrenchment After the 2008 Crisis?”, Journal of Public Policy Vol. 31 No.2, August 2011, pp. 163–86.
5 “Greece: An Update of IMF Staff’s Preliminary Public Debt Sustainability Analysis”, Country Report No. 15/186, IMF, 15 July 2015. http://www.imf.org/external/pubs/ft/scr/2015/cr15186.pdf
This article was published in ICDS Diplomaatia magazine.