With Austerity Under Fire, Countries Seek a More Balanced Solution

AusteritySix years after the onset of the global financial crisis, economists and policymakers continue to fight bitterly over how to tackle the world’s economic woes. Is fiscal stimulus the best medicine — or is fiscal austerity what’s needed?

For most of that time, the advocates of austerity have largely won out. In the U.S. and across much of Europe, governments have slashed spending in an effort to drive down deficits. While the specter of another Greece-like meltdown was behind much of the belt-tightening, austerity advocates also got a big boost from a 2010 study by a pair of well-known Harvard economists which found that high levels of government debt could substantially cut economic growth.

But with Europe sinking further into recession, the U.S. struggling to regain momentum — and the findings of the influential Harvard study now under attack — a backlash against austerity is growing. Economists and policymakers alike are raising new questions about whether stringent austerity measures have worked — or whether they are simply making a bad situation worse.

The complexity of the challenges facing the global economy — and the interconnectedness of many of the countries struggling to right their financial systems — makes that “a very difficult question to answer,” says Wharton finance professor Itay Goldstein. “Most economists will agree that having too much debt is not good over the long-term, but you certainly want to do any cutting carefully,” he notes. “If you’re going to cut expenditures or raise taxes quickly, that will have adverse implications when the economy is in recession.”

If all agree on the difficulties of the situation, however, the two main camps have taken diametrically opposed approaches to solving them. In one camp, says Goldstein, are latter-day Keynesians — those, like President Barack Obama and prominent liberal economist Paul Krugman, who believe that the government needs to ratchet up spending to help spur new investment and create jobs. When the economy is in recession, they argue, that is precisely the time governments should run deficits to make up for the weakness in private demand.

“It’s macro-economics 101, one of the things we know from the days of the [Great] Depression,” adds Bulent Gultekin, a Wharton finance professor and a former governor of the Central Bank of Turkey. “It’s straightforward Keynesianism, but it works.”

Yet many prominent conservatives, from Republican leaders like House Speaker John Boehner and vice presidential candidate Paul Ryan to German Chancellor Angela Merkel in Europe, reject the tenets of Keynesianism outright. They view piling on more debt to pay for additional stimulus — which they largely deride as ineffective — as an anathema. To these “austerians,” as Krugman has tagged them, excessive government spending and ballooning deficits are the real problems — ones they believe pose an even greater long-term danger to the global economy than recession and rising joblessness.

The arguments of austerity advocates were bolstered by an oft-cited study, “Growth in a Time of Debt,” published in 2010 by Harvard economists Carmen Reinhart and Kenneth Rogoff. After looking at debt levels in 44 countries across 200 years, the pair argued that excessive public debt — specifically, debt exceeding 90% of a country’s gross domestic product — is associated with much slower economic growth.

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Originally Published May 22, 2013 in Knowledge@Wharton