Wolfgang Münchau has an interesting article in today’s FT (see here). Not surprisingly, he highly critical of official policy towards Greece and pessimistic about the country’s prospects without a change of course. Central to the argument is that the fiscal adjustment being demanded of Greece is self-defeating: attempts to lower the primary deficit through fiscal adjustments slow the economy so much that the primary deficit actually rises.
While I agree with Wolfgang’s bottom line, I would put the problem somewhat differently. Even allowing for two-way feedback between the deficit and GDP, standard analysis shows that, all else equal, changes to the structural primary balance do lower the actual primary balance. Moreover, this result holds for any size of deficit multiplier. (See, for example, Equation 4 from Annex B here.)
But of course all else is not equal. A big part of what is holding back a Greek recovery is fear of a catastrophe, in which Greece loses official backing and is forced to default and potentially exit the euro. The tougher the conditions applied to Greece the greater is the fear that it will simply not be able to do what is required for continued support. This fear acts as a huge drag on the economy, leading spending to contract and limiting any improvement in the deficit.
Perhaps ironically, a similar phenomenon was nicely captured by Olivier Blanchard in his comment on the original expansionary fiscal contraction paper by Giavazzi and Pagano (see here pp. 111-116). After considering a version of the basic mechanism discussed by Giavazzi and Pagano, Blanchard notes:
This formalization focuses on the effects of consolidation on the expected level of output; there is another, probably equally important implication of consolidation that this formalization does not capture-the effect of consolidation on uncertainty. Consolidation may be associated, at least after a while, with a substantial decrease in uncertainty, leading to a decrease in precautionary savings, to a decrease in the option value of waiting by consumers to buy durables and by firms to take investment decisions.
While the mechanisms are similar, I think the situation is quite different for Greece today, with the actions of official creditors key to the restoration of confidence. Rather than more decisive fiscal adjustment being the route to restore confidence, a better route would seem to be less demanding conditionality for access to official loans – conditions that stand a better chance of being politically acceptable. This would reduce the pervasive fear that it will all go pear-shaped if the government fails to meet the conditions. The positive effect of reducing this fear would be to help stop the contraction in Greek economy, and should actually allow a faster improvement in the deficit, ultimately reducing risk to official creditors. Both sides could gain from a programme with better odds of success.
It is useful to revisit the arguments above in light of the excellent analysis in the IMF reports linked to by Philip. The findings in Box 1.1 of the WEO have received most attention this morning. The key message is that fiscal multipliers appear to have been underestimated. Given the robustness of the results to a variety of controls, this analysis is broadly convincing. The arguments and findings in Box 1.3 are also very interesting, showing the adverse affects of uncertainty on growth. This underlines the cost of the failure to develop crisis-resolution policies that remove the risk of a serious escalations of the crisis in the most vulnerable countries.