The Eurozone in the post-crisis period: Can austerity promote economic recovery?

Myrto Karaflos Capstone advisor: C. Randall Henning, School of International Service

University Honors Spring 2014

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Abstract

The austerity measures that have been implemented in the Eurozone periphery countries after the

global financial crisis are a controversial matter among scholars and European citizens alike. The

purpose of this paper is to determine whether the austerity policies that these countries have

adopted in order to reduce their budget deficits can promote economic recovery in the future.

After discussing the causes of the crisis in the Eurozone, this study will analyze both pro- and

anti-austerity arguments. Additionally, it will examine the debate over the value of the fiscal

multiplier, which has been cited by European Union institutions and the International Monetary

Fund as both a support for and a rebuttal of austerity. Finally, the study will look closely at the

case studies of Greece and Ireland in order to determine how austerity measures have affected

their economies. This research will demonstrate that so far, austerity has not been successful in

promoting economic recovery, and its prospects for doing so in the future are not encouraging.

Given that austerity is still necessary to ensure that the Eurozone countries receiving bailout

packages can pay back their loans, the policy cannot be eliminated completely. Instead,

European Union and International Monetary Fund officials should make austerity requirements

less stringent for Eurozone countries and place more emphasis on structural reforms, which can

promote future economic growth and the recovery of competitiveness.

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Ever since the Eurozone crisis began in 2009, the debate over whether austerity can help

the crisis-stricken countries promote economic recovery has intensified among scholars.

Austerity is defined as the policies adopted by governments, such as spending cuts and tax

increases, meant to reduce budget deficits. In general, austerity is a controversial policy because

of its short-term recessionary effects on an economy and the subsequent social costs on the

citizens. Naturally, people in the periphery countries of Greece, Ireland, and Portugal, whose

governments have adopted austerity measures as a condition for receiving bailout funds, have

protested against the unemployment, reduction in government benefits, and negative impact on

the poorer sections of society that austerity has brought about. Even though it is an unpopular

policy, however, it is a necessity meant to ensure that the periphery can reduce its public deficits,

and eventually its debt, so that the bailout loans can be repaid.

Here lies the real question. Even if it does succeed in reducing budget deficits, can

austerity in itself promote a more comprehensive economic recovery in the crisis-stricken

Eurozone countries? Its advocates believe it can. According to them, high government debt is

dangerous for an economy, since it can crowd out private investment, whereas fiscal contraction

can lead to growth by restoring confidence in the market that the country is credible and can

maintain sustainable debts. However, there are also many dissenting opinions. Other economists

argue that austerity is only effective if a few countries in the Eurozone practice it at a time; that it

has not produced the intended effects of restoring confidence or encouraging recovery; and that a

misunderstanding of the origins of the crisis led to austerity measures being implemented for the

wrong reasons. The debate has also been carried out among the members of the Troika, namely

the European Commission, International Monetary Fund, and European Central Bank, which

disagree over the effects of the austerity policies they are promoting.

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The goal of this paper is to determine whether the short-run undesirable consequences of

austerity can be justified by its promise of promoting economic recovery. Since this debate is not

only a theoretical one but one that is actually affecting the lives of many Europeans, it is

important for scholars to come to a conclusion on whether austerity is worth undertaking to the

degree at which it has already been implemented. Before progressing to the argument, however,

an important distinction must be made. The fiscal austerity measures of spending cuts and tax

increases are separate from the structural reforms that the Troika has also required of the

periphery countries as conditions for receiving their bailouts. Examples of these structural

reforms include a reduction in public sector wages, pensions, and unemployment benefits;

privatization; and an increase in the retirement age.1 This distinction is crucial since scholars

themselves have at times conflated the two. Mark Blyth, a leading anti-austerity scholar, has

defined austerity as an adjustment of the economy that involves “the reduction of wages, prices,

and public spending [in order] to restore competitiveness.”2 While it is true that policies like

public sector wage reductions are related to the fiscal austerity measure of cutting public

spending, they are not the same. Structural reforms can indeed promote competitiveness, or an

economy’s ability to compete with other countries on the international market by producing the

same quality of goods at a lower cost, since price and wage reductions can make exports cheaper

and thus more attractive. Austerity, on the other hand, cannot, since by definition it only refers to

the reduction of budget deficits. This paper will focus on the effects that fiscal austerity in itself

has had on the Eurozone periphery economies and on their prospects for recovery. The

importance of structural reforms will be addressed later on in the paper.

                                                                                                               1 Costas Lapavitsas, Crisis in the Eurozone (London: Verso, 2012), 122-123. 2 Mark Blyth, Austerity: The History of a Dangerous Idea (New York: Oxford University Press, 2013), 2. 2 Mark Blyth, Austerity: The History of a Dangerous Idea (New York: Oxford University Press, 2013), 2.

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After examining the causes of the Eurozone crisis, this study will assess both pro- and

anti-austerity arguments made by economists as well as the Troika institutions and then look

closely at how austerity has affected the economies of Greece and Ireland. The hypothesis of this

research is that austerity is problematic in a number of ways, which creates the need to reassess

its consequences and its appropriateness as a strategy for restoring economic stability in the post-

crisis period.

I. What caused the Eurozone crisis?

Before analyzing the effectiveness of austerity measures in promoting economic

recovery, it is necessary to examine the causes of the crisis in Europe. This is important because

in order for a full recovery to take place, the economic policies adopted by the periphery

countries, which include austerity measures, must address the root causes of the crisis in those

countries. However, since the core country economies of the Eurozone, like Germany and

France, are closely linked to those of the periphery, this section will examine the reasons for the

crisis across the whole of the Eurozone instead of narrowly focusing on the periphery.

It is widely accepted that the bursting of the housing bubble in the United States served as

the trigger for what was to become a global financial crisis. The Eurozone countries, however,

experienced the crisis differently in that it developed into a sovereign-debt crisis in addition to a

financial one. One of the most significant causes of the Eurozone crisis was the loss of

competitiveness in the periphery countries as compared to the core ones. After the introduction

of the euro, countries like Greece, Spain, and Portugal experienced a large increase in wages that

did not correspond to a proportional increase in productivity.3 Furthermore, Germany kept a

                                                                                                               3 Lorenzo Bini Smaghi, Austerity: European Democracies Against the Wall, The Centre for European Policy Studies, July 10, 2013: 45. http://www.ceps.be/book/austerity-european-democracies-against-wall.

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strict downward pressure on its wages, thereby increasing its competitiveness relative to the

periphery.4 Faced with this disadvantage and their own inflated wages, the periphery countries

were forced to accumulate debt in order to compensate for their lack of competitiveness.

Namely, they attempted to increase demand through investment in real estate and consumption,

which was financed by loans from abroad.5

The ease with which the periphery states were able to borrow this money has also been

cited as a cause of the crisis. Since the introduction of the euro, the countries that adopted it were

able to borrow money at cheap rates. Periphery states were given the same credit rating as

Germany, even though the riskiness of their bonds was not comparable. This happened because it

was assumed that the European Central Bank would back all Eurozone countries’ debt, since it

was all issued in the same currency.6 With their high credit rating, therefore, the periphery

countries were able to borrow money at lower rates, something that they took advantage of.

Aside from government debt, however, the private sector also accumulated a significant amount

of debt by borrowing from core country banks.7 According to some experts, it was the private

sector debt that became more problematic during the crisis than the government debt. The

importance of this point to the question of whether austerity is an effective response to the crisis

will be discussed further in this paper.

With respect to how the crisis unfolded in the major Eurozone powers, much of the blame

has been placed on their banks. It is true that some periphery countries borrowed beyond their

means, but the loans they took out came from the core country banks. Without their participation,

it is unlikely that the government debt of a country like Greece would have reached such high

                                                                                                               4 Lapavitsas et al., Crisis, 84. 5 Ibid., 91-92. 6 Blyth, Austerity, 62-63. 7 Lapavitsas et al., Crisis, 90.

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levels. When the periphery countries proved unable to pay back their loans, the core country

banks were in trouble: it was difficult for their governments to bail them out due to the large

amount of sovereign debt they held and the inability of European central banks to print their own

money.8 While many banks were bailed out, the cost to the governments, as well as to the

confidence of asset-holders, was high.

The final widely-cited cause of the crisis in Europe lies in the inherent weakness of

adopting a common currency. Despite the lower transaction costs and exchange rate stability that

the Eurozone countries have enjoyed since 2002, they have given up the ability to use monetary

policy as a corrective tool during economic crises. As Paul Krugman has pointed out, countries

like the United States, Britain, and Japan also have high debt levels, but their borrowing costs

remained low during the crisis. This is largely due to the market’s confidence in their ability to

repay their loans.9 Since the above countries have their own currency and central banks with the

ability to print money, they can theoretically always pay back their debt by printing more money.

Eurozone countries, however, do not have independent monetary policies, so confidence in their

ability to pay back the large amounts of debt they had accumulated was very low. Reflecting this

risk, interest rates on the periphery countries’ bonds shot up, which led to the countries losing

access to bond markets and having to resort to rescue packages organized by the European Union

and International Monetary Fund. Therefore, high debt seems to be especially problematic for

the Eurozone as a currency union, whereas countries with an independent currency were not

affected as much by it during the global crisis.

                                                                                                               8 Blyth, Austerity, 6.  9 Krugman, Paul, “How the Case for Austerity has Crumbled,” The New York Review of Books, June 6, 2013. http://www.nybooks.com/articles/archives/2013/jun/06/how-case-austerity-has-crumbled/?pagination=false.

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Having examined the causes of the Eurozone crisis, this paper will now assess the

arguments both for and against austerity measures as a method of promoting economic recovery

in the affected countries. Knowing the causes of the crisis will be useful in determining whether

or not austerity can help resolve the internal problems of the periphery countries.

II. Pro-austerity arguments

The arguments in support of austerity that will be analyzed here rest on the beliefs that

high debt levels can be damaging for an economy and that spending cuts can help to boost

growth. One of the most influential recent arguments that has been used as a justification of

austerity came in 2010 from the Harvard economists Carmen Reinhart and Kenneth Rogoff.

Although they do not specifically advocate for austerity, their hypothesis surrounding the

damage that high debt can cause implies a general support for fiscal conservatism. The two

economists analyzed data from countries with instances of very high public debt, which they

defined as the debt-to-GDP ratio exceeding 90% for at least 5 years, and discovered that the

majority of the countries experienced slower growth.10 According to their findings, only those

countries with a debt-to-GDP ratio of above 90% experienced lower growth rates by several

percentage points,11 so the figure of 90% was widely established as a threshold that must not be

exceeded.

What is Reinhart and Rogoff’s reasoning for why high debt inhibits growth? Their first

explanation has been used by a number of pre- and post-Keynesian economists as an argument

against excessive government borrowing. Namely, high debt has the potential to crowd out                                                                                                                10 Carmen M. Reinhart, Vincent R. Reinhart, and Kenneth S. Rogoff, “Public Debt Overhangs: Advanced Economy Episodes Since 1800,” Journal of Economic Perspectives 26 (2012): 70, 81. http://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.26.3.69. 11 Carmen M. Reinhart and Kenneth S. Rogoff, “Growth in a Time of Debt,” The National Bureau of Economic Research, Working Paper 15639, January 2010: 2. http://www.nber.org/papers/w15639.

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private investment12 because of the rise in interest rates that occurs when the government is

issuing a large number of securities. This would divert funds away from private investment as

citizens find it more expensive to borrow money. The second reason for why high debt can slow

growth lies in the market’s low confidence that governments can indeed pay off their debt.

According to Reinhart and Rogoff, as debt levels rise, so does the uncertainty of whether loans

will be repaid to creditors. This in turn leads to a sharp rise in the interest rates on government

securities, which makes it even more difficult for the government to repay its debt. In order to

exit this vicious circle, the government must tighten its fiscal policy and avoid accumulating

more debt in order to restore its credibility. 13 Therefore, Reinhart and Rogoff indirectly promote

fiscal austerity as a way of avoiding the excessively high debt levels that can lead to slower

growth for a country.

Another well-known pro-austerity argument comes from two other Harvard economists,

Alberto Alesina and Silvia Ardagna, who determined that spending cuts tend to lead to economic

growth rather than contraction. The pair focused their research on advanced countries and came

to the conclusion that market confidence plays a significant role in economic growth, much as

Reinhart and Rogoff did. The reason why fiscal austerity leads to growth is that it creates

confidence in the private sector, due to the belief that more costly fiscal adjustments can be

avoided in the future and to the subsequent lowering of the interest rate. This boost in confidence

can in turn lead to more investment and consumption. The growth originating from the private

sector will then offset any contraction caused by the decrease in government spending.14 Overall,

                                                                                                               12 Reinhart, Reinhart, and Rogoff, “Public Debt Overhangs,” 79-80. 13 Reinhart and Rogoff, “Growth in a Time of Debt,” 23. 14 Alberto F. Alesina and Silvia Ardagna, “Large Changes in Fiscal Policy: Taxes Versus Spending,” The National Bureau of Economic Research, Working Paper 15438, October 2009. http://www.nber.org/papers/w15438.  

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both pairs of economists believe that austerity can benefit an economy due to its positive

confidence effects on the market. There are many others, however, who claim that austerity has

the opposite effect during a crisis, leading to stagnation and even contraction of the economy.

III. Anti-austerity arguments

After the adoption of austerity measures by several Eurozone countries as a condition for

receiving the bailout funds from the Troika, there has been much criticism of the policy. Some

cite the economic hardship that the citizens of those countries are now experiencing as evidence

against the appropriateness of implementing a strict form of austerity. Overall, austerity has led

to a rise in unemployment, an increase in the number of people living below the poverty line, and

several social costs, such as reduced access to public health care. There is a general consensus,

however, that austerity is bound to produce undesirable consequences in the short run. The more

important question is if it can help the periphery countries recover and improve the stability of

their economies in the long run. There is much debate on this topic, and despite the fact that

austerity measures have been implemented as a way to promote recovery, many experts believe

that they are instead damaging the long-term potential of those economies.

First of all, the findings of the Harvard economists cited above have been criticized as

misleading. Scholars from the University of Massachusetts discovered that Reinhart and

Rogoff’s data analysis was inaccurate due to an Excel spreadsheet error. After the error was

fixed, their 90% debt-to-GDP ratio threshold was no longer binding. The corrected study instead

showed that countries with debt-to-GDP levels above 90% did not consistently exhibit slower

growth than lower-debt countries, as the economists had originally claimed.15 Furthermore, as

                                                                                                               15 Les Leopold, “Is the Entire Deficit Debate Based on a Big Mistake?”, The Huffington Post, April 18, 2013. http://www.huffingtonpost.com/les-leopold/reinhart-rogoff-debt-deficit_b_3110663.html.

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Paul Krugman has argued, there was no evidence in the original study that the correlation

between high debt and low growth implied causation.16 It could easily be the case that low levels

of growth lead to a large accumulation of debt, much like the periphery countries turned to

foreign borrowing as a way of boosting domestic demand to compensate for their stagnant

productivity and lack of competitiveness. Overall, after the discovery of the error, many

economists discredited the Reinhart and Rogoff study.

Krugman has also argued against the Alesina and Ardagna study being used to justify

austerity measures as a response to the global crisis. As he wrote, experts have found that none

of the examples of fiscal contraction that the pair used in their study took place in the middle of a

recession.17 Thus, while their claim that fiscal austerity can lead to growth may be correct in the

case of a healthy economy, it should not be used as a justification for the austerity measures

imposed on the crisis-stricken European countries.

Besides the faults found in these popular pro-austerity arguments and their inapplicability

to the Eurozone crisis, this paper will examine three other reasons for which austerity has been

criticized as inhibiting growth in the long run. First of all, a number of scholars cite the fallacy of

composition problem, or the mistaken belief that something is true of the whole just because it is

true for only part of that whole.18 19 20 This proposition maintains that austerity will not promote

economic recovery if the entire Eurozone practices it at once. For austerity has not only been

imposed on the periphery countries; some of the core countries, like Germany, have also been

practicing it (albeit in a less severe form) as an attempt to recover from the recession. This is

                                                                                                               16 Krugman, “Case for Austerity has Crumbled.” 17 Ibid.  18 Lapavitsas et al., Crisis. 19 Paul De Grauwe and Yuemei Ji, “The Legacy of Austerity in the Eurozone,” The Centre for European Policy Studies, October 4, 2013. http://www.ceps.eu/book/legacy-austerity-eurozone. 20 Blyth, Austerity.

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problematic for the periphery countries, however. As Mark Blyth argues, if a country is

deleveraging, or trying to pay back its debts all at once, it will be dependent on exports for

growth. Of course, there needs to be somebody to buy those exports, and if the core countries

within the Eurozone are trying to cut back on spending themselves, the periphery cannot depend

on them to buy their products.21 Essentially, Blyth is making the argument that if austerity is to

be tolerable, the healthier economies in the Eurozone have to increase their spending in order to

help the periphery grow. If not, the gap in competitiveness, which has been cited as a major

cause of the crisis in the periphery, will remain. Germany has been exerting downward pressure

on its wages for years, and if it continues to employ fiscal austerity and thus have low public

spending, its wages will not increase and the periphery cannot become more competitive.22

Overall, scholars who cite the fallacy of composition argument claim that austerity in the

periphery itself is not enough. It only has a chance of being effective if core countries

counterbalance it by stimulating their own economies, which a country like Germany may not

have a high incentive to do due to its long tradition of fiscal conservatism.

A second argument against implementing austerity measures as a way of cutting budget

deficits and thus promoting economic recovery is based on the observation that austerity simply

does not produce the intended effects. The first part of the argument centers on investor

confidence and essentially denies austerity advocates’ claim that cutting spending and reducing

debts can boost confidence. A recent IMF study showed that in 2011, a country’s short-term

growth affected spreads more than its long-term growth potential did. In other words, when

investors saw that a country’s GDP was shrinking, they assigned a higher risk premium to that

country’s government bonds, causing the interest rate on the bonds to increase and spreads to

                                                                                                               21 Ibid., 10-11. 22 Lapavitsas et al., Crisis, 124-125.  

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become higher. The study demonstrated that a tighter fiscal policy can lead to higher spreads

because it damages the prospect of short-term growth and negatively affects market confidence.

Therefore, an attempt to cut the deficit too quickly through austerity measures could actually

result in a higher debt-to-GDP ratio as a country’s debt becomes more expensive to pay off.23

Essentially, the IMF’s study showed how market confidence can be negatively affected by

austerity measures because of investors’ focus on the short-term rather than the long-term growth

of a country. This idea directly contradicts the pro-austerity arguments that cutting spending can

increase confidence because it restores credibility and makes the economy more stable.

The second part of the argument that austerity does not produce the intended effects

centers on the belief that austerity measures in the Eurozone were implemented prematurely.

Paul Krugman argues that the measures should have been implemented later on, when the

periphery economies would have been stronger. His reasoning lies in the fact that the

contractionary effects of a reduction in government spending can be offset if the central bank

cuts interest rates in order to increase investment and private spending. Since 2010 however,

when some crisis-stricken countries began implementing austerity measures, interest rates have

been very low.24 Therefore the European Central Bank, had it wanted to use this monetary policy

tool to ease the contractionary effects of austerity, could not. Krugman argues that if austerity

policies had been put in place later when the economy was stronger and interest rates were

higher, periphery countries might not have suffered as much from the sharp decrease in

government spending. Of course, one must take into consideration that the Eurozone is a special

case since the member states share one central bank and have a single monetary policy. It is not

always the case that the ECB chooses an interest rate that is beneficial to all member states, so it                                                                                                                23 “The IMF’s Latest Forecast: Perverse Austerity,” The Economist, January 24, 2012. http://www.economist.com/blogs/freeexchange/2012/01/imfs-latest-forecast-3. 24 Krugman, “Case for Austerity has Crumbled.”

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cannot be guaranteed that the bank would cut the interest rate in order to compensate for fiscal

austerity in only a section of the Eurozone. If a higher interest rate was more beneficial to the

core countries, the ECB might choose that instead. Even so, Krugman’s argument is a valid one

from the point of view that the central bank would at least have the choice to cut interest rates,

whereas at the time when austerity policies took effect, it did not.

The third argument for why austerity is not effective in promoting recovery is that its

advocates misunderstand the origins of the Eurozone crisis. As discussed in the first section,

several scholars claim that the private debt accrued by periphery countries after their adoption of

the euro was the problem, rather than the government debt that is so often cited as excessive.25

The exception to this is Greece, since the causes of the crisis there were different than in other

countries (this will be discussed later on). In terms of misunderstanding the origins of the crisis,

Lorenzo Bini Smaghi has proposed that the real problem was the periphery countries’ excessive

balance of payments deficits, rather than their government debts. He claims that the fiscal crisis

was a result of the imposition of austerity on these economies, since balance of payments deficits

can only be corrected through increasing an economy’s competitiveness and not through

reducing aggregate demand.26 One of the goals of austerity measures was the reduction of public

debt through reducing deficits, but since public debt was not the cause of the crisis, as Bini

Smaghi argues, the contractionary effects of fiscal austerity simply pushed the economies deeper

into recession without correcting the actual problem.27 Thus, he does not believe that austerity

can promote recovery in the periphery countries. His recommendation for the correct way to

                                                                                                               25 Paul Krugman, “Europe’s Austerity Madness,” The New York Times, September 27, 2012. http://www.nytimes.com/2012/09/28/opinion/krugman-europes-austerity-madness.html. 26 Bini Smaghi, Austerity, 46. 27 Ibid., 48.

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address the crisis is to encourage exports and make the economy more open to international

trade.28

Given the above, the focus on reducing public debt, which Bini Smaghi finds

problematic, should be examined further by those who promote austerity. As Krugman pointed

out, other advanced economies with high levels of public debt were not as affected during the

crisis because of their ability to print their own money. Therefore, it might not be public debt in

itself that is dangerous, but rather investors’ reactions to it. Furthermore, Mark Blyth and other

scholars have blamed the crisis on the banking system rather than on governments,29 as Bini

Smaghi also posits. The core country banks inflated their balance sheets to a point that was

unsustainable, with many of their assets coming from the private sector of periphery countries. If

one accepts this argument, then the focus placed on reducing government debt has been

excessive and Bini Smaghi’s hypothesis that austerity is not treating the actual problem is valid.

The debate over whether austerity is helping or hurting the Eurozone countries affected

by the crisis is still ongoing. While some economists condemn high government debt and

recommend spending cuts as a way to promote growth, others decry austerity as an ineffective

and politically conservative policy. The arguments against austerity are many: it cannot work if

everybody is practicing it, it has significant contractionary effects, and its targeting of

government debt is misleading. Since the major studies used to justify the implementation of

austerity have proven to be faulty, anti-austerity scholars have voiced their opposition even more

loudly than before. The debate has not only taken place among scholars, however. The European

Commission, International Monetary Fund, and European Central Bank have also voiced

                                                                                                               28 Ibid., 46. 29 Blyth, Austerity, 6.

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differing opinions on the effect of fiscal contraction in an economy based on the ambiguous

measure of the fiscal multiplier.

IV. The fiscal multiplier: High or low?

The concept of the fiscal multiplier originates in Keynesian theory and refers to the

percentage change in GDP resulting from a 1% change in government spending or taxation.30

The multiplier can be less than 1, in which case a 1% increase in spending would lead to a less

than 1% increase in GDP. It can also be greater than 1, in which case a 1% decrease in spending

would lead to a loss of GDP of greater than 1%. The value of the multiplier is arbitrary since it

depends on factors like the size of the particular economy in question, the marginal propensity to

consume in that economy, and which stage of the business cycle the economy is in. Therefore,

the debate over the fiscal multiplier has centered on what value should be assigned to it for the

Eurozone countries in the midst of the crisis. The question of how much austerity should be

required rests largely on each institution’s interpretation of the multiplier, so this issue is

important in the debate over austerity.

In the paper they wrote recommending fiscal expansion when an economy is in recession,

economists Brad De Long and Lawrence Summers found that the fiscal multiplier is higher

during an economic downturn than in a healthy economy. More specifically, if there are no

supply constraints, or cases when supply is not high enough to meet demand, and interest rates

are very low, then the multiplier may be double that of an economy experiencing normal

                                                                                                               30 “The fiscal multiplier in forecast models: A short summary of the recent debate,” European Parliament, January 30, 2013: 1. http://www.europarl.europa.eu/document/activities/cont/201301/20130130ATT60071/20130130ATT60071EN.pdf.

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growth.31 The International Monetary Fund made a similar argument in 2012, when it explained

its recent inaccurate growth forecasts by claiming that it had underestimated the size of the fiscal

multiplier in European economies post-crisis. Instead of the assumed value of 0.5, the multiplier

could have been as high as 1.7 according to the IMF, so that the fiscal consolidation taking place

during this period led to lower growth than expected.32 Due to the higher value of the multiplier,

the percentage decrease in government spending or the percentage increase in taxation caused a

larger decrease in GDP than that original percentage change. Related to the IMF’s argument

about fiscal contraction is De Long and Summers’ defense of fiscal expansion during a crisis,

since that high multiplier in the latter case would magnify the positive effects of higher spending

or lower taxes in the economy. According to them, a depressed economy with interest rates close

to zero and a relatively high fiscal multiplier can afford to implement expansionary fiscal policy

without adding a future burden to the economy.33 De Long and Summers are clearly against

implementing strict austerity during a recession, and while the IMF did not specifically make a

similar policy recommendation, its findings on the fiscal multiplier provoked a reaction from the

European Commission.

The Commission responded to the IMF study by suggesting that it was not necessarily the

case that the IMF underestimated the fiscal multiplier’s value. Instead, it posited that the IMF’s

forecasts for 2010 actually underestimated the growth level in European economies instead of

overestimating it, since growth was higher than the IMF’s prediction.34 This does not follow

from the IMF’s claim that the fiscal multiplier was higher than expected. Instead, the

                                                                                                               31 J. Bradford DeLong and Lawrence H. Summers, “Fiscal Policy in a Depressed Economy,” The Brookings Institution, Spring 2012: 233-234, 245. http://www.brookings.edu/~/media/Projects/BPEA/Spring%202012/2012a_DeLong.pdf. 32 “The Fiscal Multiplier in Forecast Models,” 1-2. 33 DeLong and Summers, “Fiscal Policy,” 262-263.  34 “European Economic Forecast: Autumn 2012,” European Commission, August 2012: 41. http://ec.europa.eu/economy_finance/publications/european_economy/2012/pdf/ee-2012-7_en.pdf.

  18

Commission acknowledged that the multiplier may be higher than normal during a crisis, due to

higher credit constraints and low interest rates, but it insisted that the value is still less than 1.35

In effect, according to its interpretation of the multiplier, the Commission did not consider

austerity as problematic as the IMF did, since a cut in spending or an increase in taxes would not

lead to as much of a decrease in GDP as the IMF had predicted. The disagreement among

members of the Troika about the impact of austerity measures is evident.

The European Central Bank also joined in the debate by making a distinction between the

short and long run. In the short run, the ECB stated that fiscal contraction has a negative effect

on GDP, so the fiscal multiplier is high. In the long run, however, fiscal contraction can affect

GDP growth positively, so the multiplier is smaller.36 In essence, the ECB is making the

argument that even if austerity hurts the economy in the short run, it is the long-run growth that

deficit and debt reduction can lead to that matters most. Overall, these institutions’

interpretations of the fiscal multiplier reflect their differing views on the austerity measures

implemented in the Eurozone periphery. In the case of Greece, for example, which will be

examined more closely below, the ECB advocated for a strict fiscal adjustment plan, while the

IMF wanted a more lenient one. In other words, the ECB was focusing on austerity’s presumed

long-term benefits, and the IMF was concerned about its short-term contractionary effects. The

fiscal multiplier has thus been one of the major justifications for either a strict or more flexible

austerity policy.

V. Austerity in practice

So far, this paper has explored some of the major theoretical arguments for and against

                                                                                                               35 Ibid., 44. 36 “The Fiscal Multiplier in Forecast Models,” 2.  

  19

austerity. While these provide a good basis for understanding the concept of austerity and its

implications, it is also important to analyze how austerity has been put into practice and what

effects it has produced in the Eurozone periphery countries. Broadly speaking, the results have

not been positive. The austerity programs that began in 2010 have not yet reduced the

government debt-to-GDP ratios in the crisis-stricken countries. The ratios have instead

increased.37 Furthermore, for every 1% increase in austerity, which is measured by the change in

the cyclically adjusted primary budget, there has been a 1.4% decrease in output.38 Therefore, if

austerity really does encourage recovery in the long run, that point has not yet been attained in

the Eurozone. Another issue that many have with austerity is its impact on the poor, which is

significantly greater than on the rich. The poor, who rely more on government services like

public education, health care, and public transportation, are bound to suffer more when the

government cuts back on its spending.39 Some see this as especially unfair, since the banks and

those people and businesses that took on an excessive amount of credit played a large role in the

onset of the crisis. Critics of austerity claim that the poor are now paying for the misdeeds of the

rich.40 Besides this general criticism of austerity policies, however, there is also a large amount

of detailed information on how they have affected the economies of Eurozone countries since

2010. Before looking at two specific case studies, it is necessary to point out an inherent

weakness in analyzing the effects of austerity so soon after the crisis. As noted earlier, there is a

general consensus among economists that fiscal contraction will produce recessionary effects in

the short run. The long run, which is when austerity is supposed to promote economic recovery

and stability, has not yet come. Even though it is difficult to know exactly what effects austerity

                                                                                                               37 De Grauwe and Ji, “The Legacy of Austerity,” 2. 38 Ibid., 3. 39 Blyth, Austerity, 14. 40 Ibid.  

  20

will bring in the future to the Eurozone periphery, it is still possible to make predictions based on

current trends. Therefore, the following discussion of austerity measures in Greece and Ireland

will be conducted with that caveat in mind. While one cannot know for certain what today’s

fiscal contraction will bring in the future, current statistics plus the theoretical background on

austerity discussed above can at least contribute to an estimate of austerity’s effectiveness.

VI. Case study: Greece

Greece’s economic troubles after the beginning of the global crisis were some of the most

widely publicized among the Eurozone countries. Since 2010, the country has received two

bailout packages from the Troika as well as a debt restructuring in order for it to be able to repay

its debt. As a condition for receiving this aid, Greece has had to implement a variety of strict, and

thus widely unpopular, austerity measures. The question is if the high economic and social cost

of austerity can be justified by its promise to stabilize the Greek economy in the future. The goal

of this section is to look at how austerity policies were implemented in the country and what the

effects have been thus far. Before doing this, however, it is worth examining the causes of the

crisis in Greece, since they are different from those in other Eurozone periphery countries.

While the other southern European countries and Ireland experienced problems due to

private sector excess, Greece was plagued by its loss of control over public finances. The trouble

began in 2009, when the newly elected government discovered that previous ones had been

grossly misreporting the budget deficit, which turned out to be around 15% of GDP instead of

the reported 4%.41 Additionally, Greece had a large problem with tax evasion, which may have

                                                                                                               41 David Jolly, “2009 Greek Deficit Revised Higher,” The New York Times, November 15, 2010. http://www.nytimes.com/2010/11/16/business/global/16deficit.html.

  21

reached as high as 27.5% of GDP in the period from 1999 to 2007, making it the largest among

EU countries.42 Another issue that contributed to the country’s large deficit and debt was its

inflated public sector salaries, which were around 130% higher than private sector ones. The

average difference in the Eurozone was about 30%.43 Therefore, the excessively high public

sector salaries, combined with the government’s inability to collect the necessary revenue

through taxes, resulted in a large deficit, which was not properly reported to European Union

authorities. Debt was also high due to Greece’s borrowing from other Eurozone countries in

order to finance its deficit. When it became apparent to the international community that

Greece’s finances were so out of order, confidence in its ability to repay its debt plummeted.

Greek bonds were downgraded and the interest rate on them increased rapidly, indicating a much

higher risk.44 Investors rushed to sell them, and Greece was no longer able to rely on the market

for much-needed funds, so it had to turn to the European Commission, International Monetary

Fund, and European Central Bank for a bailout package in order to avoid default.

Given the large amount of aid Greece received from the Troika, austerity measures were

naturally implemented both as a form of conditionality and to ensure that the country would be

able to repay the loans that constituted its bailout package. On its part, the ECB advocated for a

strict austerity program. As the ECB argued, if the program was put into effect quickly, and if it

encompassed structural reforms to the Greek economy as a way of improving competitiveness, it

would help make Greece’s debts more sustainable. It would also lower borrowing costs and

boost the country’s credibility and international markets’ confidence. The IMF, on the other

hand, pushed for a less strict program that had fewer requirements for fiscal adjustment and

                                                                                                               42 “The True Cost of Austerity and Inequality: Greece Case Study,” Oxfam, September 2013: 1. http://www.oxfam.org/sites/www.oxfam.org/files/cs-true-cost-austerity-inequality-greece-120913-en.pdf. 43 Ibid., 2.  44 Blyth, Austerity, 63-64.

  22

conditionality. One possible reason for its more flexible stance is the widespread criticism for its

strict structural adjustment programs implemented in the Asian countries that were involved in

the 1990’s financial crisis.45 One will also remember that a couple of years later, as discussed

above, the IMF made its argument about high fiscal multipliers and their implications for fiscal

contraction, which suggests that the institution maintained its support of less strict austerity

throughout the crisis.

In the end, however, Greece was forced to adopt strict austerity measures, whose

ambitious goal was to reduce the deficit by 13.6% of GDP to below the Stability and Growth

Pact’s 3% limit by 2014 and to stabilize the debt at 140% of GDP.46 Even though austerity was

necessary in order to reduce Greece’s excessive deficit and debt, the deadlines that the Troika set

for reducing them were not far away, and the measures that had to be taken in order to meet these

deadlines were severe. Some clearly fell into the category of fiscal austerity: the value-added tax

(VAT), or the tax on consumption of goods and services, was raised from 21% to 23%, and

public sector salaries were reduced as a result of cuts in government spending. Other measures

involved structural adjustment of the economy, as the ECB had recommended. The retirement

age was increased to 67 in 2012, while before the crisis one could retire as early as 58; there

were cuts in pensions and bonuses; the restrictions relating to the laying off of workers were

loosened; and there were several reforms of the tax system in order to make it more efficient.47 48

Unsurprisingly, these reforms and spending cuts were met with protest among the

Greeks, who blamed the European Union and the IMF for exacting too harsh a punishment on

the poor and the retirees. Some Europeans, like the Germans, considered the measures to be just,                                                                                                                45 Carlo Bastasin, Saving Europe: How National Politics Nearly Destroyed the Euro (Washington, D.C.: The Brookings Institution, 2012), 175. 46 Ibid., 193-194.  47 Bastasin, Saving Europe, 194. 48 “Greece Case Study,” 2.

  23

given that Greece’s debts were not just the fault of the government, but also of those citizens

who avoided paying taxes and remained silent in the face of corruption. Whatever the reactions

that austerity measures produced, however, the fact is that they were unavoidable if Greece was

to receive funds from the Troika. The real question is if the severity of the measures was justified

and, more importantly, what effects they have had so far on the Greek economy. The impact has

on the whole been negative. Since 2010, Greece’s national income has decreased by a quarter

compared to pre-recession levels. Unemployment is above 27%, and for those under 25, it is

above 58%.49 According to an Oxfam study conducted on the effects of austerity measures in

crisis-stricken countries, more than 1 in 3 Greeks fell below the poverty line in 2012, and

economic inequality is increasing. Furthermore, 17.5% of the population in the same year lived

in households with no income. There are also a number of social costs, such as a less accessible

public health system, with 1 in 3 Greeks having no public medical insurance; an increase in the

crime rate; and rising extremism in the form of racism.50

Clearly, at least the short-term effects of austerity in Greece have been harsh. Are there

prospects for economic recovery in the long term? The economist Mark Weisbrot does not

believe there are, as he projects growth in 2014, not due to austerity, but to an EU-funded

stimulus program for highway construction. Overall, he argues that austerity has not had a

positive impact on the Greek economy so far. According to him, austerity can only be effective if

the unemployment level it leads to can reduce wages enough for the economy to become more

competitive and be able to export in order to promote growth. This point has not yet been

reached in Greece, despite a projection from the IMF of a 20% decrease in wages for the period

                                                                                                               49 Mark Weisbrot, “Greece: Signs of Growth Come as Austerity Eases,” The Guardian, January 22, 2014. http://www.theguardian.com/commentisfree/2014/jan/22/greece-growth-austerity-eases-europe-imf. 50 “Greece Case Study,” 5-6.  

  24

from 2010 to 2014.51 If this is the case, for how long can Greek society endure more austerity

along with its short-term contractionary effects in order for the economy to show substantial

improvement? For however necessary austerity measures were deemed to be by the Troika, the

fact is that so far, they have worsened the economic condition in Greece to a point that is both

harmful for Greeks themselves and for the country’s prospects of repaying its debt in the future.

It is true that Greece attained a primary budget surplus in 2013 that exceeded its targets, and that

it succeeded in selling government bonds on the market in April 2014,52 but these improvements

still cannot mask the underlying problems. Greece’s debt-to-GDP ratio increased dramatically

after austerity measures were implemented and has only recently fallen, but it is still above pre-

crisis levels.53 There has also been talk of a third bailout, and growth has been stagnant. At least

for the time being, austerity has not been effective in promoting recovery, and the social cost has

been very high. The positive aspect of the bailout’s conditionality requirements has been the

structural reforms made in the Greek economy, such as the tax system and public sector reforms,

which, if effective, could help Greece avoid a similar crisis in the future. Besides this, however,

the severity of the measures and their impact on society have been a burden on the Greek

economy rather than an improvement. It remains to be seen how long it will take for austerity

policies to promote recovery in Greece, or if the measures will be lifted before this has time to

happen.

                                                                                                               51 “Greece: Signs of Growth.” 52 “Greece qualifies for new debt relief after 2013 budget surplus,” ekathimerini.com, April 23, 2014, http://www.ekathimerini.com/4dcgi/_w_articles_wsite2_1_23/04/2014_539158. 53 “Greece Government Debt to GDP,” Trading Economics. http://www.tradingeconomics.com/greece/government-debt-to-gdp.

  25

VII. Case study: Ireland

In contrast to Greece, Ireland is considered by many to be the “success story” among the

Eurozone periphery countries. Although it too had to adopt austerity measures as a condition for

receiving funds from the Troika, it managed to exit its bailout program in December 2013 after

just three years of its implementation. While some point to Ireland as an example of how

austerity can be successful, others argue that the Irish recovery is overstated. In this section, the

Irish crisis will be analyzed, and the effectiveness of austerity measures in Ireland will be

assessed.

Contrary to Greece, the crisis in Ireland began as a private sector one instead of a

sovereign debt one. In the 1990’s, Ireland was undergoing a property boom that led to a large

investment in real estate. Low interest rates and reckless lending by the banks had caused land

values to rise significantly. Capital inflows into the country had increased wages, but increases in

productivity were lower, leading to the property development sector of the economy becoming

uncompetitive.54 The property bubble eventually burst in 2008, perpetuating a banking crisis

whose cause was an excessive amount of borrowing from the banks in order to invest in real

estate. Irish banks were unable to pay back the loans they had taken out from other banks, so the

government decided to bail them out. At this point, Irish government debt increased

dramatically.55 As happened in most other European periphery countries, except for Greece,

Ireland’s public debt became unsustainable only as a result of the crisis, which originated in the

private sector. This point complements Lorenzo Bini Smaghi’s argument that in most cases,

government debt was not the problem and that perhaps austerity measures are targeting the

wrong variable and causing unnecessary hardship. Has this been a problem in Ireland, which has

                                                                                                               54 Bastasin, Saving Europe, 230-231. 55 Blyth, Austerity, 65-67.

  26

finally succeeded in managing its finances without the Troika’s help? The answer to this

question lies in examining the effect of austerity measures on the Irish economy and the extent to

which the country has really recovered from the crisis.

In 2010, it was confirmed that Ireland would receive a €67.5 billion loan from the

Troika.56 As in Greece, the Irish government was required to adopt austerity measures in order to

get its public finances back on track and to ensure that it would be able to eventually pay back its

bilateral loans. These measures also had a contractionary effect on the economy, along with high

social costs. Several of the negative effects had also occurred in Greece: a rise in unemployment,

especially among young people; a cut in social welfare payments; an increase in the number of

households that earn no income; and a rise in inequality, with the measures disproportionately

affecting the poor. They experienced larger decreases in disposable income and higher taxation

rates than did the rich.57 58 Additionally, the cost of living and housing has greatly increased,

which acts as a further disadvantage when combined with high taxation and unemployment.59

Finally, Ireland has experienced a great wave of emigration, with close to 400,000 people

leaving the country since the start of the crisis. 90,000 of those left between April 2012 and April

2013.60 Contrary to Greece, however, Ireland did not have to implement as many politically

unpopular structural reforms, since institutions like its tax system were more efficient and thus

                                                                                                               56 Henry McDonald, “Ireland becomes first country to exit eurozone bailout programme,” The Guardian, December 13, 2013. http://www.theguardian.com/business/2013/dec/13/ireland-first-country-exit-eurozone-bailout. 57 “The True Cost of Austerity and Inequality: Ireland Case Study,” Oxfam, September 2013: 2-3. http://www.oxfam.org/sites/www.oxfam.org/files/cs-true-cost-austerity-inequality-ireland-120913-en.pdf. 58 Fintan O’Toole, “Ireland’s Rebound is European Blarney,” The New York Times, January 10, 2014. http://www.nytimes.com/2014/01/11/opinion/irelands-rebound-is-european-blarney.html?src=me&ref=general. 59 “Ireland Case Study,” 1-2. 60 O’Toole, “Ireland’s Rebound European Blarney.”  

  27

did not need to be changed.61 Nevertheless, austerity in itself took a high toll on society, which

has reacted negatively towards this forced imposition of fiscal contraction. In a hopeful turn of

events, Ireland announced in December 2013 that it would be able to fund itself into 2015

without the Troika’s help after implementing the spending cuts, asset sales, and reforms required

under the bailout. The country is now able to borrow on the international market once again. This

news does not mean that the Irish economy has fully recovered, however. Austerity measures

must still continue to be implemented so that Ireland can reduce its high public debt level, which

reached 124% of GDP in 2013.62

Part of the criticism of austerity in Ireland surrounds the origins of this public debt.

Besides measures being imposed on private citizens, the Troika also insisted that Ireland

continue to fund its troubled banks, which greatly contributed to increasing its public debt.63

Although officials admitted in retrospect that the guarantee of banks had not been a good policy

choice, the fact remains that this requirement nullified austerity’s proposed goal of reducing

debts and led to more austerity being needed today and in the future. This circumstance calls into

question Ireland’s supposed recovery as a result of successful austerity policies. First of all, as

Krugman points out, Ireland’s GDP per capita is still lower than pre-crisis levels, so in his mind

the country has not really recovered from the crisis.64 Even taking into account that austerity

generally causes an economy to shrink in the short run, which is what Krugman is arguing, its

long-term effects are also uncertain if one considers the theoretical arguments against the policy.

Ireland has succeeded in the sense that the markets are now confident enough to let the country

                                                                                                               61 Padraic Halpin and Harry Papachristou, “Why Greece can’t match Ireland’s recovery success,” Financial Post, July 11, 2012, http://business.financialpost.com/2012/07/11/why-greece-cant-match-irelands-recovery-success/. 62 McDonald, “Ireland First Country to Exit.” 63 O’Toole, “Ireland’s Rebound European Blarney.” 64 Paul Krugman, “Success, European Style,” The New York Times, January 13, 2014. http://krugman.blogs.nytimes.com/2014/01/13/success-european-style/.

  28

borrow money from them, but its economy remains weak. Had the Troika not insisted that

Ireland keep funding its banks, the country’s public debt would now be lower, and there would

be less of a need for strict austerity in order to correct it. One wonders whether the Irish economy

could have been stronger today had austerity measures been less severe, given that the public

debt was largely a result of the crisis and not something endemic, like in Greece.

VIII. Conclusion

After examining both the theoretical arguments surrounding austerity and how it has been

put in practice in Greece and Ireland, the question remains whether it can be effective in

promoting recovery from the crisis in the long run. In terms of theory, the answer is still

ambiguous. The two pro-austerity arguments examined in this paper have been disproven as

legitimate justifications for the post-crisis implementation of austerity. Reinhart and Rogoff’s

spreadsheet error nullified their argument that a high debt-to-GDP ratio is dangerous. Empirical

evidence has also invalidated their claim: countries like the United States and Japan have a high

level of debt, but their independent currencies prevented that debt from becoming a problem

during the crisis. Additionally, Alesina and Ardagna’s claim that spending cuts are followed by

expansion does not apply to countries undergoing a recession. Besides the refutation of pro-

austerity arguments, anti-austerity scholars have made several legitimate claims of their own.

The periphery countries cannot recover if the whole Eurozone is practicing austerity; austerity

has not restored confidence and may have been employed prematurely; and its focus on reducing

government debt has often been misguided. Despite the strength of these arguments, however,

they mainly focus on the short-run and on whether austerity should have been implemented to

such a degree in the first place. One cannot know with absolute certainty what austerity’s long-

  29

term effects might be, although one can make predictions based on current trends. Given this, the

question becomes whether it is worth waiting to find out.

Greece and Ireland’s experience with austerity measures has not been encouraging. Their

short-term recessionary effects have had a heavy toll on the Greek and Irish economies and

societies, and substantial economic recovery has not yet begun. Even austerity’s more limited

goal of restoring sustainable debts has not been accomplished, since both countries’ debt-to-GDP

ratios shot up after austerity measures were implemented. Furthermore, its very targeting of

government debt may be too narrow a focus. Besides Greece, the periphery countries were hit by

the crisis due to their banks, not their governments’ excessive borrowing. So has austerity been

misguided, or even unnecessary? The answer is no. In order to receive the bailout funds, Greece

and Ireland had to undergo some form of austerity in order to lower their debts enough to

become credible in the international market and be able to once again borrow in it. Austerity was

the only way that the Troika could ensure that the bilateral loans made to these two countries

would one day be paid back. However, the severity of the austerity measures may have been

excessive. Even if austerity can lead to economic stability in the long run, the fact is that Greece

and Ireland’s economies are far from a complete recovery, and competitiveness, which is

necessary for their long-term growth potential, has not been restored. What these countries

would truly benefit from are the structural reforms that the Troika has already requested,

especially in Greece, such as the reform of tax systems and public sector pay, which can

strengthen the economies in the long run by promoting competitiveness. Structural reforms, if

implemented correctly, have the power to promote long-term growth because of their permanent

nature and their ability to reduce wages enough to make exports cheaper and more competitive.

Thus, a reasonable recommendation would be to require a less severe form of austerity, so that

  30

the countries can work on lowering their deficits, while placing a greater emphasis on structural

reforms. Whether large spending cuts and tax increases can in themselves really make a

difference in the Eurozone periphery in the future is not known. For now, however, they are

exacting high economic and social costs without any foreseeable benefits in the near future.

  31

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