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The Misleading Allure of Delaying Adjustment in the Euro Area Periphery



The latest policy debate on the euro area debt crisis concerns whether austerity has gone too far too soon, causing excessive recessions in some countries and making them less creditworthy rather than more so. The International Monetary Fund (IMF) has found that it had been underestimating the multiplier and therefore overstating projected output paths of countries involved in fiscal tightening (IMF 2012a, 41–43, Blanchard and Leigh 2013). De Grauwe and Ji (2013) have argued that undue panic stampeded countries into excessive fiscal tightening, but their implicit assumption is that the European Central Bank (ECB) should have announced Outright Market Transactions (its prospective program of purchases of sovereign debt of troubled countries taking adjustment measures) much earlier so financial markets would not have caused the panic in the first place. The European Commission (EC) has replied that the decline in spreads after OMT was linked to "concomitant consolidation efforts" (Buti and Carnot 2013). Krugman (2013) has riposted that the EC is laboring under "delusions" and should "be urging those countries not suffering from a debt crisis to be engaged in offsetting expansion" while acknowledging that those swept up in the crisis "have no choice about imposing at least some austerity."

A crucial consideration in the debate concerns the high multiplier under conditions of high unemployment and ineffective monetary policy (zero-bound on the interest rate). The argument is that fiscal contraction under these conditions raises rather than lowers the debt/GDP ratio, by depressing the denominator more than it increases the numerator. It turns out, however, that under reasonable assumptions this paradox is transitory, and over time the austerity reduces rather than increases the debt ratio (albeit at some loss of output from tightening under high-multiplier conditions).

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Note: For comments on an earlier draft, I thank without implicating Anders Åslund, Joseph Gagnon, and Angel Ubide.

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