# Can Austerity Be Self-defeating?

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2 run and ha he long-run impac of a lower defici on he deb/ GDP raio will herefore jus be equal o he reducion of he defici iself. Second, even assuming ha he impac of a (permanen) cu in public expendiure on GDP is permanen, his lower GDP level remains a one-off effec whereas he lower defici coninues o have an impac year afer year hus making i cerain ha any iniial increase in he deb raio will be reversed over ime. The key quesion in he conex of he curren euro area crisis is hus wheher financial markes focus on he shor or long run. Prospecive buyers of Ialian 0-year bonds should look a he longer run impac of defici cuing on he deb level, which is prey cerain o be posiive. Of course, if markes are no raional and reac only o he shor-run effec, he resul migh be differen. Simple Formal Analysis The usual equaion describing he dynamics of he deb/gdp raio is derived from he budge consrain which says simply ha he deb a he end of he presen period is he sum of he defici and he deb level a he end of he previous period. B = Deƒ + B - () This is hen divided by GDP o yield: B Deƒ = B + - ( -) Y () Y Y Y - Y where B sands for public deb (bonds), Deƒ for he defici and Y, as usual, for GDP. Denoing he GDP raios by lower case leers (b = deb/gdp and deƒ = defici/gdp) and g as he growh rae as usually defined g = Y -, his can be rewrien Y- as: b = deƒ + b - [ + g (deƒ )] - () where he noaion g (deƒ ) indicaes ha he growh rae is a funcion of he defici, wih a higher defici assumed o lead o higher growh. The magniude of he firs derivaive of g(deƒ) is usually called he fiscal muliplier. The impac of a defici on he deb raio is hus given by: If one uses he approximaion ha [ + g (deƒ )] - = (which is a good approximaion wih growh raes of only a few percenage poins), his can be rewrien as: b = - b- muliplier () deƒ I follows ha a lower defici will no improve he deb raio if: b - muliplier This condiion would be saisfied a ypical European (or US) deb raios if he muliplier exceeds uniy. For example, i would be saisfied for a counry wih a saring deb raio greaer han one (such as Ialy s 0%) and assuming ha he fiscal muliplier is also a leas equal o one. Wha would be a ypical value for he muliplier in realiy? I urns ou ha i is difficul o deermine a range given ha here is lile agreemen in he lieraure on he magniude of even he shor-run mulipliers. More Keynesian models end o have larger mulipliers, ofen higher han one. More forward-looking models end o have lower mulipliers, because agens in hese models end o lower expendiure already in he presen in anicipaion of he higher axes hey will have o pay in fuure. One addiional problem negleced here is ha he deb/gdp raio is obained by dividing he nominal deb by nominal GDP, whereas mos macroeconomic models are consruced in real variables. However, given he (persisenly) low level of inflaion a presen in he euro area, his should no affec he resuls if all he variables are inerpreed as deviaions from a baseline. However, he shor-run muliplier should be larger if one looks a he impac of a cu in expendiure on nominal GDP (as opposed o real GDP). To analyse he longer run, one has o go beyond he curren period. One could consider he curren period as he shor run and he nex period he long run. The long-run deb would hus be given by he sum of he deb a he end of he curren period and nex period s defici: B + = Deƒ + + B = Deƒ + + Deƒ + B - () I is somewha more difficul o rewrie his in erms of he habiual raios o GDP. The resuling expression now conains of course wo growh raes: curren (shor-run) and fuure (longrun). b = - b- [ + g (deƒ )]- g () deƒ deƒ The sign of he impac of a lower defici on he deb raio hus depends on he magniude of he saring deb/gdp raio and he magniude of he fiscal muliplier. B + Deƒ = + Deƒ + ( Y ) -( -)( + B Y Y Y ) (7) + Y + Y Y + Y - Y Y + Clearly he fuure deb/gdp raio depends on fuure deficis and growh raes. Two simple cases are of ineres: 7 Inereconomics 0

3 a) A emporary cu: he curren defici is cu, bu he fuure defici reurns o baseline. In his case GDP should also reurn o baseline (i.e. Y + = Y - ). This implies ha a emporary cu in he defici mus improve he long-run deb/gdp raio regardless of any deerioraion in he deb raio ha migh have maerialised in he shor run. Seing he baseline defici a zero, he long-run increase in he deb raio can be wrien as: B + - b - = deƒ [ + g + (deƒ )]- = ~ deƒ () A emporary cu in he defici should hus reduce he longrun deb raio by approximaely he amoun of he defici reducion, regardless of wha happens o he deb raio in he shor run. The (shor-run) muliplier does no maer for he long run. b) A permanen cu in defici (i.e. deƒ + = deƒ ). In his case one could discuss wheher GDP reurns o baseline or no. In mos macro models, his would be he case, bu i is useful o consider he case when a permanen reducion in he defici leads o a permanen drop in aciviy (i.e. Y + = Y ). In his case equaion (7) collapses o: b + = + deƒ - b - [ + g (deƒ )]- g deƒ = + deƒ = + - b - muliplier (0) This shows ha he condiion for fiscal adjusmen o be selfdefeaing is now less likely o be saisfied, since he produc of he muliplier and he saring deb/gdp raio mus now exceed wo. Conclusion So wha should governmens do? Abandon auseriy because financial markes migh be shor-sighed? This would only delay he day of reckoning, as deb raios would increase in he long run. A counry which eners a period of heighened risk aversion wih a deb overhang has only bad opions from which o choose. Implemening credible auseriy plans consiues he lesser evil, even if his aggravaes he cyclical downurn in he shor run. I is hus difficul o argue ha he peripheral counries in he euro area should abandon aemps o reduce heir deficis because he resuls will arrive only in he long run. B + = Deƒ + + Deƒ + B -( Y -) (9) Y + Y + Y Y - Y Wih he defici raio consan, his implies: See P. de Grauwe: Who cares abou he survival of he eurozone?, Cenre for European Policy Sudies, CEPS, hp:// book/who-cares-abou-survival-eurozone. Rainer Maurer Why Auseriy Can Become Self-defeaing for Member Saes of a Currency Union Despie all effors o reduce governmen budge deficis, debo-gdp raios in crisis-hi member saes of he Economic and Moneary Union (EMU) are sill growing faser han expeced. A he same ime, GDP growh performance is poor and, according o mos forecass, is likely o worsen. These developmens increase concerns over wheher hese counries will be able o pay back heir ousanding debs. These concerns are empirically measurable by he correlaion beween ineres rae spreads on governmen bonds and governmen deb-o- GDP raios (Figure ). This correlaion has no always been as srong as i currenly is. Table shows ha he degree of correlaion has been growing since he financial crisis of 00. Deb-o-GDP raio spreads are calculaed as follows: he spread of counry j relaive o Germany is equal o he deb-o-gdp raio of counry j minus he deb-o-gdp raio of Germany. Consequenly, he daa poin for Germany appears a he origin of he diagram. De Grauwe and Ji canno rejec he hypohesis of a srucural break around he year 00. Before 00, he explanaory power of he deb-o-gdp raios had been much lower and only marginally significan. P. De Grauwe, Y. Ji: Mispricing of Sovereign Risk and Muliple Equilibria in he Eurozone, CEPS Working Documen, No., Brussels 0. This is in line wih resuls by L. Schuknech, J. von Hagen, G. Wolswijk: Governmen Bond Risk Premiums in he EU Revisied: he impac of he financial crisis, ECB Working Paper No., M. Arghyrou, A. Kononikas: The EMU sovereign-deb crisis: Fundamenals, expecaions and conagion, Cardiff Economics Working Papers, E00/9, Universiy of Cardiff, 00; V. Borgy, T. Laubach, J.-S. Mesonnier, J.-P. Renne: Fiscal Policy, Defaul Risk and Euro Area Sovereign Bond Spreads, mimeo, Banque de France, 0; and H. Gibson, G. Hall, G. Tavlas: The Greek Financial Crisis: Growing Imbalances and Sovereign Spreads, Working Paper, Bank of Greece, Ahens, March 0. ZBW Leibniz Informaion Cenre for Economics 77

4 Figure Ineres Rae Spread of Ten-Year Governmen Bonds vs. Deb-o-GDP Raio Spread in Relaion o Germany, EMU Member Saes, 0 Ineres spread in per cen Sources: Eurosa, AMECO, own calculaions. 0 Porugal Ireland Cyprus Ialy Slovenia Mala Slovakia Spain Belgium Luxembourg Neherlands Ausria France Finland Correlaion Coefficien = Germany Deb-o-GDP raio spread in per cen Greece However, Table also shows ha here is a srong and growing correlaion beween ineres rae spreads and GDP growh gaps relaive o Germany. Figure displays he corresponding diagram for he year 0. I seems ha markes do no only care abou differen deb-o-gdp raios bu also abou differen degrees of GDP growh performance. A common explanaion of he imporance of GDP growh for he abiliy of governmens o service heir debs lies in he fac ha GDP represens he ax base of he governmen. If he ax base grows rapidly, i is easier for a governmen o service ousanding deb. This becomes obvious in he formula for he primary surplus of he governmen budge which is necessary o keep he deb-o-gdp raio consan : pˆ = (i - g ). b where pˆ represens he primary surplus-o-gdp raio for period necessary o keep he deb-o-gdp raio for period consan (in he following deb-o-gdp raio sabilising primary surplus ), i is he average nominal ineres rae he governmen has o pay on is ousanding deb, g sands for he nominal growh rae of GDP and b represens he deb- Where he growh gap of counry j relaive o Germany is equal o he German GDP growh rae minus he GDP growh rae of counry j. Growh raes are calculaed on a nominal basis, since nominal raes are needed in he following o calculae deb-o-gdp sabilising primary surpluses. Real GDP growh gaps display a similar srong correlaion wih ineres rae spreads, however. W. H. Buier, K.M. Klezer: Governmen Solvency, Ponzi Finance and he Redundancy and Usefulness of Public Deb, NBER Working Papers, No. 07, 99. The primary surplus equals he oal surplus minus ineres paymens on ousanding deb. The formula follows from seing he ime derivaive of he deb-o-gdp raio b = B /GDP equal o zero: b / = -p + (i - g ). b = 0, where by definiion P /GDP and B / = -P + i. B. o-gdp raio. The higher he deb-o-gdp raio sabilising primary surplus pˆ, he more difficul i is for a governmen o keep is deb-o-gdp raio consan and hence he higher he risk of a governmen defaul on is deb. The formula clearly shows ha he lower he nominal GDP growh rae g and he higher he ineres rae for he deb service i are, he higher will be he deb-o-gdp raio sabilising primary surplus. If he GDP growh rae g is higher han he ineres rae i, he governmen will be able o run a primary budge defici pˆ < 0 and neverheless sabilise is deb-o-gdp raio. If, however, he GDP growh rae g is smaller han he ineres rae i, a governmen mus run a primary budge surplus pˆ > 0 o sabilise is deb-o-gdp raio. In his case, he governmen mus use he primary budge surplus o buy back deb. Consequenly, a higher deb-o-gdp raio b will only cause a need for a higher primary budge surplus if he GDP growh rae is smaller han he ineres rae. Figure shows he average ineres rae for he deb service i for each of he crisis-hi eurozone counries and Germany, measured by he raio of oal governmen ineres paymens Table Correlaion Coefficien wih Ineres Rae Differenials Year Deb-o-GDP raio differenial Nominal GDP growh gap Deb sabilising primary surplus gap Gaps and differenials relaive o Germany. Sources: Eurosa, AMECO, own calculaions. 7 Inereconomics 0

5 Figure Ineres Rae Spread of Ten-Year Governmen Bonds vs. Nominal GDP-Growh Gap in Relaion o Germany, EMU Member Saes, 0 Ineres spread in per cen 0 Porugal Cyprus Spain Ialy Slovenia Slovakia Mala Ausria Belgium France Finland Luxembourg Neherlands Correlaion Coefficien = Germany Sources: Eurosa, AMECO, own calculaions. Ireland Nominal GDP growh gap in per cen Greece o he level of ousanding governmen deb for he previous year, as available from he AMECO daabase. I is obvious ha he ineres differenials on ousanding deb compared o Germany are no ye exremely large. If he nominal GDP growh rae of hese counries were % (say % real growh and % inflaion), Ireland and Spain could sabilise heir deb-o-gdp raios, even wih a small primary budge defici (-0.% and -0.% respecively). Greece, Porugal and Ialy would need only relaively small surpluses (0.9%, 0.% and 0.% respecively) despie heir relaively large deb-o- GDP raios. However, given heir acual much lower growh performance, significanly higher primary budge surpluses are necessary o sabilise heir deb-o-gdp raios (Ireland.0%, Spain.0%, Greece.%, Porugal.%, Ialy.%). If one calculaes he deb-o-gdp raio sabilising primary surpluses for he eurozone member saes according o he above formula and subracs from hese values he corresponding value for Germany ( deb sabilising primary surplus gaps in he following), he differences are large. As Figure shows, he resuling deb sabilising primary surplus gaps also display a very srong correlaion wih he curren ineres rae spreads on en-year governmen bonds. The correlaion is even sronger han ha for he deb-o-gdp raio spreads (Figure ) and for GDP growh gaps (Figure ). As Table shows, his correlaion has also been growing since 00. European Commission: AMECO daabase 0, hp://ec.europa.eu/ economy_finance/ameco/user/serie/selecserie.cfm, 0. Ineres paymens of general governmen including flows on swaps and forward rae agreemens (UYIGE) divided by general governmen consolidaed gross deb (UDGG) of he previous year from he AMECO daabase as available on February 0 (las updae 0 November 0). Values for 0 are forecass of he EU Commission. I seems ha curren ineres rae spreads are no only influenced by deb-o-gdp raios; economic growh also has a very srong impac. The sronges correlaion resuls are for deb sabilising primary surplus gaps a value ha combines deb-o-gdp raios and GDP growh raes in a meaningful way. Thus, economic policy sraegies o figh he European deb crisis mus consider heir consequences for economic growh, oo. The following secion will show ha policies focusing on a mere reducion of governmen budge deficis are likely o be counerproducive. The Perils of Pure Defici Reducion Defici reducion policies can affec he deb-o-gdp raio sabilising primary surplus via wo channels, as he formula pˆ = (i - g ). b shows: via he direc impac on he growh Figure Average Ineres Raes on Ousanding Governmen Deb in per cen Ireland Greece Spain Ialy Porugal Germany Yearly governmen ineres paymens (UYIGE) in per cen of ousanding governmen deb of previous year (UDGG). Sources: AMECO. ZBW Leibniz Informaion Cenre for Economics 79

6 Figure Ineres Rae Spread of Ten-Year Governmen Bonds vs. Deb-Sabilising Primary Surplus Gap in Relaion o Germany, EMU Member Saes, 0 Ineres spread in per cen 0 Ireland Porugal Cyprus Slovenia Ialy Slovakia Mala Ausria Neherlands Spain Belgium Finland France Correlaion Coefficien = Luxembourg Germany Deb sabilising primary surplus gap in per cen Sources: Eurosa, AMECO, own calculaions. Greece rae g / and via he impac on he deb-o-gdp raio b /. The average ineres rae i on ousanding deb is deermined by he pas and will no change immediaely. The derivaive of he deb-o-gdp raio sabilising primary surplus pˆ wih respec o he governmen defici raio deƒ = Deƒ / GDP hen equals: Consequenly, he firs componen of he derivaive is negaive. The sign of he second componen is less obvious. In Daniel Gros's aricle on pages 7-77 of his issue, he derives a formula for his equaion based on he ideniy which relaes he ousanding deb levels of wo differen periods o each oher: pˆ = - g b + b (i - g ) B = Deƒ + B - A negaive value of his derivaive means ha a reducion of he governmen defici leads o he need for a larger governmen primary surplus o sabilise he curren deb-o-gdp raio, i.e. pˆ / deƒ < 0. The immediae impac of a reducion of governmen spending on GDP growh is ypically negaive from an empirical poin of view, i.e. g / > For example, recen papers by A. Acconcia, G. Corsei, S. Simonelli: Mafia and Public Spending Evidence on he Fiscal Muliplier from a Quasi-Experimen, CEPR Discussion Paper No. 0, 0; G. C h o- dorow-reich, L. Feiveson, L. Liscow, W. Woolson: Does Sae Fiscal Relief During Recession Increase Employmen? Evidence from he American Recovery and Reinvesmen Ac, in: American Economic Journal, forhcoming 0; J. Clemens, S. Miran: The Effecs of Sae Budge Cus on Employmen and Income, Working Paper, Harvard Universiy, 0; L. Cohen, J. Coval, C. Mallow: Do Powerful Poliicians Cause Corporae Downsizing?, in: Journal of Poliical Economy, Vol. 9, No., 0, pp. 0-00; P. Fishback, V. Kachanovskaya: In Search of he Muliplier for Federal Spending in he Saes During he New Deal, NBER Working Paper No., 00; E. Nakamura, J. Seinsson: Fiscal Simulus in a Moneary Union Evidence from US Regions, NBER Working Paper No. 79, 0; D. Shoag: The Impac of Governmen Spending Shocks Evidence on he Muliplier from Sae Pension Plan Reurns, Working Paper, Harvard Universiy, 0; and D.J. Wilson: Fiscal Spending Jobs Mulipliers Evidence from he 009 American Recovery and Reinvesmen Ac, Working Paper, Federal Reserve Bank of San Francisco, 0, find fiscal mulipliers wih values beween. and.. Dividing his equaion by GDP a ime and aking he firs derivaive wih respec o he defici raio yields he following equaion 9 : pˆ g = - b - ( + g ) Gros simplifies his equaion by approximaing ( + g ) =. From his, we obain he condiion for a reducion of he debo-gdp raio in case of a reducion of he defici raio: b > 0 <=> > b - g This condiion shows ha a reducion of he defici raio is likely o cause an increase of he deb-o-gdp raio if he debo-gdp raio is larger han 00%, b - is greaer han, and he fiscal muliplier g / is no less han. By he end of 0, he following crisis-hi counries experienced deb-o- GDP raios larger han 00%: Greece (%), Ireland (0%), Porugal (0%) and Ialy (0%). In hese counries, using D. G r o s : Can Auseriy be Self-defeaing?, in: Inereconomics, Vol. 7, No., 0, pp Technical deails are available in an appendix a hp:// Appendix-Why%0Auseriy%0can%0be%0Self-defeaing.pdf. 0 Inereconomics 0

7 he approximaion ha ( + g ) =, a fiscal muliplier no less han is sufficien o cause an increase of he deb-o-gdp raio in case of a reducion of he defici raio. Noe ha he approximaion used by Gros is no harmless and favours a posiive value of he derivaive when GDP growh is negaive. In Greece, for example, g 0 = -.% such ha he facor / ( + g ) equals.. Consequenly, in he shor run boh componens of he derivaive of he deb-o-gdp raio sabilising primary surplus wih respec o a reducion of he governmen budge defici are mos likely negaive. Thus a reducion of he defici raio increases he deb-o-gdp raio sabilising primary surplus pˆ / < 0. An ineresing quesion is, of course, wha happens in he longer run? Gros complemens his shor-erm analysis wih a long-erm analysis, which leads him o he conclusion ha he probabiliy of self-defeaing defici cus ges smaller in he long run, even in he case where a permanen reducion in he defici leads o a permanen drop in aciviy. 0 Here Gros akes he derivaive of he deb-o-gdp raio wih respec o he defici raio over a ime span of wo periods: B + = Deƒ + + Deƒ + B - Under he assumpion ha he reducion of he defici raio is permanen, deƒ = deƒ +, and ha i leads o a permanen reducion of economic growh, g / = g + /+, and using he approximaion ( + g ) = ( + g + ) =, he following derivaive resuls according o Gros : b + = + - b - g This expression leads Gros o he conclusion ha he condiion for fiscal adjusmen o be self-defeaing is now less likely o be saisfied, since he produc of he muliplier and he saring deb/gdp raio mus now exceed wo. However, his conclusion is based on an algebraic flaw. I presume ha he reason for his flaw is ha Gros uses he assumpion /( + g + ) = Y /Y = before he akes he derivaive. In he + echnical appendix, I provide a deailed formal and graphi- 0 D. Gros, op. ci., p. 77. Gros's (D. G r o s, op. ci., p. 77) original formula is = b + deƒ = + deƒ g - b - [ + g (deƒ )] - = + - b deƒ. - muliplier, where he erm muliplier sands for g / (see my echnical appendix). D. Gros, op. ci., p. 77. Available a hp:// can%0be%0self-defeaing.pdf. cal inerpreaion of Gros s procedure. Under he above assumpions, he correc formula is : b + = - (deƒ + b - ) g Consequenly, he probabiliy ha he derivaive of he debo GDP raio in period + wih respec o he defici raio in period is posiive, i.e. ha b + > 0 <=> > ( deƒ + b - ) g is no necessarily higher han in he above shor-erm analysis. The decisive poin is ha in he correced formula he facor appears in fron of he deb-o-gdp raio b -. As a resul, he likelihood of he derivaive having a posiive value becomes higher han in he shor-erm analysis only if he defici cu is large enough o cause a budge surplus, i.e. deƒ < 0. However, for deb-o-gdp raio b - greaer han, relaively high budge surpluses are necessary o ensure a posiive sign of he derivaive. If governmens are e.g. for poliical reasons no able o urn heir budge deficis ino surpluses, and he deb-o-gdp raios are large enough, he derivaive will remain negaive. As he following secion shows, his is he scenario for all crisis-hi eurozone counries wih he excepion of Spain, where he deb-o-gdp raio was sill close o 70% by he end of 0. Consequenly, exending he derivaive b +n / over n periods does no increase he likelihood of a posiive value and hus a possible decrease of he deb-o-gdp raio sabilising primary surplus pˆ / > 0. If capial markes respond o a higher deb-o-gdp raio sabilising primary surplus, as Figure suggess, wih a demand for higher risk premiums on governmen bonds, he average ineres rae for he service i of ousanding governmen deb (Figure ) will rise from period o period, making i more and more difficul for governmens o reach he growing deb-o-gdp raio sabilising primary surplus. In such a scenario, auseriy policy can in fac become self-defeaing. To overcome such a siuaion, a emporal shif in he fiscal muliplier g / > g +n /+n is necessary bu no sufficien. A emporal shif of he sign g / > 0 > g +n /+n would be sufficien. I is quie possible o consruc heoreical models where such shifs ake place wihin a couple of periods, and he economy recovers afer a while o is previous Ibid. My echnical appendix also shows he resul for b + /. ZBW Leibniz Informaion Cenre for Economics

8 Figure Curren Accoun Surpluses and Inflaion Differenials of EMU Founding Member Saes, Per cen of GDP Curren Accoun Surpluses Germany The Neherlands Luxembourg Finland Belgium Ausria France Ialy Ireland Spain Porugal Greece Per cen In relaion of he inflaion average of EMU founding member saes. Source: Eurosa. Inflaion Differenials Germany The Neherlands Luxembourg Finland Belgium Ausria France Ialy Ireland Spain Greece Porugal pah. However, here is reason o be scepical ha he assumpions of hese kinds of models are fulfilled for member saes of a currency union wih over-indebed privae secors. Some empirical argumens for why i may ake much more ime for he economies of such counries o recover possibly oo much ime from a poliical poin of view are provided below. The Developmen of Secoral Balances in Crisis-Hi Eurozone Counries To assess he consequences of auseriy policies on he growh performance of crisis-hi EMU counries, i is useful o ake a look a he deb hisory of hese counries. From he beginning of he EMU unil he oubreak of he financial crisis in 00, norhern member saes wih below average inflaion raes experienced curren accoun surpluses, while souhern member saes wih above average inflaion raes experienced curren accoun deficis (Figure ). As a conse- Luxembourg is a signifi can excepion o his rule. Since he beginning of he EMU, Luxembourg experienced above-average inflaion raes bu displayed relaively high curren accoun surpluses neverheless. This is mos likely due o he special fi scal incenives ha helped o ransform is economy ino a leading European financial marke cenre. Since 999, is curren accoun surplus in services has quadrupled, mainly due o he srong increase in he surplus in fi nancial and insurance services. A he same ime, is curren accoun defi ci of rade in goods has nearly more han doubled (Eurosa: Balance of paymens by counry [bop_q_c], hp://epp.eurosa.ec.europa.eu/ poral/page/poral/saisics/search_daabase, 0, Las updae: 7..0). Inereconomics 0

9 Figure Secoral Savings and Real GDP Growh Greece Real GDP growh in per cen Real GDP growh (lef scale) Governmen savings (righ scale) Secoral savings in per cen of GDP 0 Privae secor savings (righ scale) Foreign counry savings (righ scale) Real GDP growh in per cen Real GDP growh (lef scale) Governmen savings (righ scale) Porugal Secoral savings in per cen of GDP Privae secor savings (righ scale) Foreign counry savings (righ scale) Spain Ireland Real GDP growh in per cen Secoral savings in per cen of GDP Real GDP growh in per cen Secoral savings in per cen of GDP Real GDP growh (lef scale) Privae secor savings (righ scale) Real GDP growh (lef scale) Privae secor savings (righ scale) Governmen savings (righ scale) Foreign counry savings (righ scale) Governmen savings (righ scale) Foreign counry savings (righ scale) Ialy Germany Real GDP growh in per cen Secoral savings in per cen of GDP Real GDP growh in per cen Secoral savings in per cen of GDP Real GDP growh (lef scale) Privae secor savings (righ scale) Real GDP growh (lef scale) Privae secor savings (righ scale) Governmen savings (righ scale) Foreign counry savings (righ scale) Governmen savings (righ scale) Foreign counry savings (righ scale) Foreign counry savings = Inverse curren accoun balance. Source: AMECO. ZBW Leibniz Informaion Cenre for Economics

10 quence, norhern member saes buil up ne wealh posiions, while souhern member saes buil up ne deb posiions. One explanaion for his developmen lies in he fac ha he nominal ineres raes of EMU member saes converged wih he beginning of he moneary union. In he presence of diverging inflaion raes, his implies higher real ineres raes in norhern, low inflaion member saes and low real ineres raes in souhern, high inflaion member saes. Following sandard microeconomic heory, his should have resuled in an incenive for norhern member saes o save and for souhern member saes o spend. 7 Despie he common rend of growing naional indebedness, secoral ne saving paerns of crisis-hi eurozone counries have been quie differen. As Figure shows, in Greece and Porugal curren accoun deficis (ligh green line) accompanied he negaive ne savings of he privae (dark green line) and governmen secors (grey line) unil he year 00. In Ireland and Spain, however, he governmen secor did no accumulae large amouns of deb unil he crisis year 00. In hese counries he curren accoun defici was accompanied insead by he growing indebedness of he privae secor in Spain, of course, significanly more so han in Ireland. In Ialy, on he conrary, he privae secor accumulaed posiive ne savings, while he governmen secor did ran ino deb. Consequenly, wih he excepion of Ialy, hese counries enered 00 wih over-indebed privae secors. The increased uncerainy and reduced credi supply a he sar of he financial crisis caused households and companies in hese counries o sar a process of deleveraging which sill persiss, as Figure shows. I is very likely ha he privae secors of hese crisis-hi eurozone counries will ry o furher reduce heir ousanding deb in he coming years. A leas, households and companies will no be able o run he same deficis as in he pas. 7 As argued in R. Maurer: The Eurozone Deb Crisis A Simple Theory, Some No So Pleasan Empirical Calculaions and an Unconvenional Proposal, Working Paper, 00, hp://ssrn.com/absrac= or hp://dx.doi.org/0.9/ssrn., his can lead o self-enforcing deb spirals: if a signifi can fracion of all goods bough by high inflaion counries wih credis received from low inflaion counries is non-radable (e.g. real esae, local services, ec.), hese credis will cause excess demand for goods in high inflaion counries and excess supply of goods in low inflaion counries. As a consequence, inflaion differenials will no disappear and will give rise o furher credi flows from low inflaion counries o high infl aion counries. According o an ideniy which can be derived from he expendiure accoun of Gross Naional Produc, he sum of all secoral savings of an economy mus always equal zero (see secion of he echnical appendix). The daa for Figure are from he AMECO daabase of he European Commission. Governmen savings equal ne savings of all governmen insiuions (UBLG in AMECO); Privae Secor Savings equal ne household savings (UBLH in AMECO) plus ne corporae savings (UBLC in AMECO); Foreign Counry Savings equal he inverse curren accoun balance (UBLA in AMECO). Consequenly, domesic privae demand for goods and services will be lower han before. Therefore, i is simply no plausible o assume ha he privae secor will be able o sabilise oal demand as soon as governmens reduce heir deficis. This is ypically he case in sandard business cycle models. Bu he assumpions on which hese models are based do no apply o he presen siuaion in he crisis-hi eurozone counries. Urging he governmens of hese counries ino a period of susained auseriy will herefore mos likely deepen he recession over he nex few years and could lead o unforeseeable poliical consequences. The silver bulle o cope wih hese problems would of course be a simulaion of demand by an increase of expors. This would generae curren accoun surpluses necessary o pay back ousanding debs. However, o make goods and services of he crisis-hi eurozone counries inernaionally compeiive, heir prices mus fall. In counries wih heir own currencies, a reducion of domesic demand would rigger a devaluaion of he domesic currency, which would reduce expor prices. For counries which are members of a currency union, his pah is blocked. Insead, hey mus ry o devaluae heir real exchange raes, i.e. lower heir producion coss compared o heir credior counries. This is cerainly no an easy ask vis-à-vis credior counries like Germany. A leas, i should be plausible o assume ha under such circumsances, a successful real devaluaion will ake much more ime han a nominal devaluaion by counries wih heir own currencies. In he meanime, a surplus in he curren accoun balance which, as shown in Figure, is necessary for a selemen of secoral balances if governmens are urged o lower heir deficis will only be possible if domesic incomes fall furher, causing a sufficien decrease of impor demand. Hence under such circumsances a deepening of he curren recession is necessary o balance he curren accouns of he crisis-hi eurozone counries. This, however, means ha a emporal shif in he sign of he fiscal muliplier g / > 0 > g +n /+n, which is, according o he analysis presened here, necessary o cause a reducion of he deb-o-gdp raio b +n / > 0 and, as a resul, a decrease in he deb-o-gdp raio sabilising primary surplus pˆ / deƒ > 0 is very unlikely under he presen circumsances. There is herefore good reason o doub ha he aemps o reduce governmen deficis in he crisis-hi eurozone counries will be successful in he near fuure. The danger ha auseriy may become selfdefeaing under hese circumsances is eviden. The debae will be coninued a Inereconomics 0

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