Something extraordinary happened in Europe this week. Enrico Letta, Italy’s Prime Minister nominee, upon being tapped to form the next government made a bold press conference announcement that his primary objective upon taking office will be to end Italy’s austerity program and join other leaders calling for an end to austerity across Europe. Presto! The bond markets did not go berserk. Contrary to wide expectations, instead of punishing Italy investors remained calm and did not proceed to increase its borrowing costs. And voila, the euro crisis has come to an end.
News also spread like wildfire this week about the notorious austerity paper scandal. An academic paper by the well regarded economists Kenneth Rogoff and Carmen Reinhart, which has been used by policymakers far and wide to justify their fiscal retrenchment, has been discredited. Among other high profile examples, EU Vice-President for Economic and Monetary Affairs Olli Rehn gave several prominent speeches in the early stages of the crisis explicitly basing European austerity programs on their work.
Their now infamous paper argues that once a given country reaches a 90% ratio of net public debt to GDP, economic growth will be sharply contracted. Reinhart/Rogoff touted their iron law widely, and policymakers from the Tea Party to the UK’s George Osborne were only too happy to take it to their policy hearts. But the results are in, in two senses. First, austerity itself has caused not only decreased growth but brought about even higher levels of debt compared to where countries were pre-crisis.
Second, Reinhart/Rogoff’s paper turns out to be an academic canard. The high profile economists cooked the books as it were, whether intentionally or not we don’t know. But using their data, a team at UMASS Amherst found coding errors, missing data, and the use of dates covering only a short period instead of a longer one: mistakes even grad students should not be making. With corrections however, their result essentially disappears. What is more, correlation is not causation. Even in the maligned paper itself, in lieu of an explicit causal mechanism there is only a putative association between the 90% debt level and GDP reduction. However, numerous mainstream economists argue the opposite: that sluggish growth causes ballooning debt levels.
To stip up this tempest in a teapot further, in the opening pages of the current issue of Foreign Affairs one finds an interview of Polish Foreign Minister Radoslaw Sikorski, who is tipped by many to take over when EU High Representative Ashton steps down. Sikorski talks at length about the need for continued austerity and gives great credit to Germany and Chancellor Merkel for their leadership. Sikorski has been quoted as fearing German inaction more than action. In a coup by Foreign Affairs, a few pages later Brown University professor Mark Blyth eviscerates that argument with a bevy of evidence. In the companion piece to his excellent new book, “Austerity: the History of a Dangerous Idea,” Blyth demonstrates that austerity has led everywhere to less growth and jobs and increased debt. Blyth labels the fact that normal citizens everywhere have had to pay dearly for the bailouts and other damaging policy decisions of elites as “the greatest bait and switch in history.”
Pro austerity types tend to hasten to put a spotlight on Latvia, the so-called austerity darling. But Latvia, which put in place an early austerity program, actually only started growing again when it ceased its fiscal retrenchment. Moreover, Latvia has a very small population and an atypical labor market compared to other long-standing capitalist countries.
While Keynes is turning over in his grave and the dismal science gets, well, more dismal, there is still time to in policy terms to right this wrong. We can leave the structural reform components in place, but governments everywhere need to engage in mildly expansionary fiscal and monetary policies. To its credit, oft maligned Japan is doing this very thing more successfully than any western government at present. It seems it will be left to economic historians to ponder a question that should be on all of our minds: in the face of considerable historical and recent evidence, how did this obsession with austerity ever occur in the first place?
(in case you missed Round 2 of Keynes vs. Hayek: https://www.youtube.com/watch?v=GTQnarzmTOc )