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When the facts change…
One of the things I admire most in people is when they are able to change their opinions based on new evidence, take responsibility for past mistakes, and move on. Based on that description alone, you can imagine what I think of politicians…
But in the world of economics and investing, some concepts have become articles of faith and dogma as well. One such article of faith is that increasing central bank balance sheets (i.e. printing money) must lead to inflation. And even though the last twelve years in Europe and the United States have shown that all that money printing has not only not led to inflation but if anything had deflationary consequences similar to Japan, some economists and investors insist that the monetary stimulus of 2020 will inevitably tip the scales towards rising inflation.
Another article of faith is that high government indebtedness needs to be paid with higher taxes down the road and as such is bad for future economic growth. Thus, if debt becomes too high, we need to engage in austerity measures to balance the budget. Yet, more and more studies show that the austerity measures enacted in Europe and the UK after the financial crisis and the Eurozone debt crisis have caused more damage to growth than high debt-to-GDP ratios ever could.
Ten years ago, I believed in both those articles of faith. Like so many Germans, I am naturally averse to debt and fearful of inflation. For some Germans, this aversion to debt and inflation can even become a part of their identity, with sometimes tragic consequences.
Today, I have severe doubts that either one of these two articles of faith holds true. And in return, I get ridiculed by people who know me from a decade ago and debated me back then. Their argument is that I have been wrong back then, so why should they trust me today? Well, as Keynes allegedly said…
When the facts change, I change my mind. What do you do, Sir?
Enter Olivier Blanchard. Blanchard is one of my heroes in economics because he is one of those rare economists that don’t tie their identity to a particular school of thought. In the early 2010s he was Chief Economist of the IMF and pushed hard for austerity measures in the aftermath of the financial crisis and the Eurozone Debt Crisis. In 2013, he made an astonishing U-turn, admitting that he had underestimated the negative consequences of austerity on growth. His reputation – and the reputation of the IMF – took a big hit from the mismanagement of the Eurozone Debt Crisis and some people won’t listen to his views anymore. I say you should listen to him now more than ever and give his views more weight than other economists’ who act like a broken clock and simply repeat the same dogma over and over again.
Today, Blanchard argues eloquently why we shouldn’t introduce austerity measures after this crisis. In short, it is a matter of impact. Austerity measures significantly reduce economic growth. Balancing a budget that would otherwise run a 3% to 5% deficit can easily create a recession in a country emerging from a crisis and almost certainly reduces growth by 1 percentage point or so per year for several years in a row. In the end, the cost of austerity is an almost one to one reduction of GDP in the long run. Meanwhile, cutting the deficit to zero reduces the debt-to-GDP ratio after three to five years by maybe ten percentage points. The impact on the cost of government debt is in the range of a few basis points. Hence, the benefit of reducing debt levels is measured in fractions of a percent of GDP, while the costs are several percentage points of GDP.
Austerity measures as practiced over the last decade make no sense and should be avoided. That is not to say that austerity is always ineffective. We know today that the cost of austerity can be reduced if it is backloaded, i.e. a country starts with small austerity measures and then gradually tightens the screw year by year. Similarly, deficit reductions can stimulate business confidence and foster investments overcoming the negative effect on growth from reduced government spending. However, I remain doubtful about these arguments and continue to think that they are correct, but in practice, the impact of austerity on business investment is so small as to be negligible. Otherwise, why didn’t businesses invest like crazy during the last episode of austerity?
But just because I remain doubtful about these arguments today, doesn’t mean that I won’t change my mind. If the facts change, I will change my opinion again in the future. And so should you.