Rogoff-Reinhart: Austerity and Stimulus Together Can Save the Euro Zone


Despite the Rogoff-Reinhart debacle, austerity may still have a role to play in saving the Euro if used in tandem with Keynesian economics. In an article published yesterday on PolicyMic, I wrote, “Given the difference between the structural stability of northern and southern European economies, different approaches will have to be taken to pull Europe out of recession.” By using austerity and Keynesian stimulus in those economies with dismal and strong structural integrity respectively, we may find that those economies whose unstable debt and poor management led to a trust deficit reflected in the markets may be able to achieve the reform necessary to ensure long-term stability in the euro zone.

At the root of the recent spike in coverage of the austerity/stimulus debate is the Rogoff-Reinhart Harvard study. In contrast to the flexible theories of Milton Friedman and John Maynard Keynes, the paper by Harvard professors Rogoff and Reinhart set an unambiguous quantitative theory: Countries whose debt-to-GDP ratio rises above 90% suffer significantly slower growth. The paper, “Growth in a Time of Debt,” was used as a tool for advocates of fiscal austerity to combat the Keynesian argument that “the boom, not the slump, is the right time for austerity.” Rogoff-Reinhart believed that as European debt grew in the recession, waiting for austerity would have disastrous consequences. A UMass-Amherst revision found glaring faults and omissions in the study, and concluded that in fact a country with a debt-to-GDP ration of more than 90 percent grows at an average annual rate of 2.2 per cent.  

However, this embarrassing correction is a relatively small blow to the policy of austerity. As the New Yorker rightfully pointed out, “The dispute about the Reinhart and Rogoff methodology is a storm in a teacup.” Much more damning is the IMF’s policy reversal under the leadership of Christine Lagarde, the former French finance minister. The IMF reversed its 2008-2009 recommendation of austerity to one of “increased government spending on public investment.” 

Austerity does still have big-name supporters. maintains that “governments must be prepared to impose pain to stop public debt rising out of control — to avert … the ‘squeezing out’ of the private sector which is the real engine of growth; to create headroom for debt to rise again when there’s a cyclical imperative for it to do so; and in the shorter term, to head off critical loss of market confidence.”

What both sides of this divide do agree on is that there is a point at which the burden of debt can be critical, as shown by Greece, Iceland, and Ireland. What makes these three cases different from other economies such as those of Britain, Germany, and France, is the lack of economic structural integrity that translates into a lack of confidence in government.

For the euro to be successful requires stable governments with balanced budgets, something many believed the European economies possessed almost a decade ago. However, with the realization of the structural deficiencies of governments in the euro zone, stimulus would only be a band-aid for those economies lacking a strong underlying structure. In order to ensure the longevity of the euro zone, Greece and economies like it must undergo deep reform requiring austerity. 

The Washington Post outlines parts of the structural deficiency as “corruption and lack of private-sector competitiveness, the lax tax collection, the inefficiency of the government, the extensive subsidies and monopolies and state ownership of firms, the regulatory strangulation…” Given the incentive for governments to satisfice, countries like Greece, Italy, and to a lesser extent Spain cannot be relied on to do structural reform during or after a stimulus. In addition to reform, austerity is necessary to avoid default and to bring confidence to public and private lenders.

These austerity measures can and should be coupled with Keynesian stimulus as suggested by the IMF in those economies such as Britain and Germany where expansionary policies can be effective and create long-term stability. Although it may seem odd to prescribe two vastly different solutions to countries in the same economic union, the past few years have shown that the European economies vary far more than expected. And although the Bank of England opted against stimulus last week, there is an expectation that a stimulus will be voted for when Bank of Canada head Mark Carney takes over at the Bank of England this summer.