Viv Davies: Hello and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I’m Viv Davies from the Centre for Economic Policy Research, it’s 13 September 2012 and I’m at the London School of Economics talking to Professor John Van Reenen. We discuss his recent work on fiscal consolidation, and whether he thinks that in Europe fiscal austerity has gone too far. I began the interview by asking John whether he thought fiscal austerity was self-defeating.

John Van Reenen: Fiscal austerity can be self-defeating in two senses. In a very narrow sense, if your problem that you face as an economy is what most economies in the world do face at the current time, you have relatively high structural deficits, then it might seem obvious that the way to do something about that is to reduce the deficit by increasing taxes or reducing spending, or some combination of both. In the medium term that’s absolutely true, you have to do some of that and you have to plan to do some of that, and many countries, like the US, don’t. But the problem is that if you cut too fast and too deeply during a period of recession, like in many countries like the UK for example, that can actually be self-defeating in two senses. In one sense it can be defeating in that it will exacerbate the degree of recession, so for example if you cut spending back very quickly and consumer demand falls and investment by firms falls, this is going to mean that you end up with higher unemployment and therefore lower tax revenues, because people who aren’t employed are not paying tax and also you have to pay more for welfare benefits. And as Keynes classically showed, under both circumstances you can end up having a very prolonged depression or a prolonged period of much lower output than you would have had if you took a slower path of fiscal consolidation.

The second sense in which it can be self-defeating is that you may even end up with making your budget deficit position worse. So if you have a real fall of demand generated by the austerity programme it makes such deep cuts to tax revenues and such big increases in welfare spending, that can actually mean that you end up with even lower levels of revenue and leave you with a worse budget deficit than before. So you may end up, even on the measures of just public finance, with worse public finances than you would have done had you chosen a different fiscal path. There are caveats to that because obviously in normal times an independent bank responds to low demand by things like cutting interest rates, and that’s often a much better way of maintaining demand in response to fiscal consolidation. The problem is when interest rates are close to zero the central bank can’t do that, because you can’t go below a zero interest rate. So that so-called zero lower bound means that in those circumstances the bank can’t use monetary policy in order to maintain a level of demand in the economy. That’s a big problem.

VD: So some of your recent work has really focused on fiscal consolidation during depression, particularly in the UK, and on quantifying the costs and benefits of delaying austerity measures until a recovery is clearly established. Could you briefly describe some of that research and the various scenarios that you outlined?

JVR: We wanted to think about several questions in terms of the degree to which the timing of your fiscal consolidation can make a different effect on output or on jobs. You could approach this question in different ways: as an example of thinking about that we looked at the UK case, and we looked at what would’ve happened if Britain had delayed its fiscal consolidation by three years, the idea being that the consolidation happening now is happening during a period of recession. Delaying it for three years or so would have meant that we were in a more expansionary phase. The reason you might believe that was a beneficial thing to do is that the effects of fiscal consolidation are very different depending on where you are in the business cycle. The so-called fiscal multiplier is not the same in a boom as it is in a recession, so austerity during normal times, good times or average times may have not such a big effect, whereas austerity cuts in a recession have had much more strong negative effects on the fall of demand for a variety of reasons, among them the difficulty of cutting interest rates near zero.

So we wanted to see how big those effects were quantitatively, building in the fact that there may be this differential response between booms and busts, and taking into account something that most macroeconomists don’t really account for, which is that you get what’s called hysteresis effect. That’s the idea that in unemployment increases then people who lose their jobs may lose their skills, lose their motivations, lose their networks.

VD: Why can’t those macro models include the hysteresis?

JVR: In principle they can do, it’s just that typically most macro models don’t do that because it makes them more complex and many people don’t believe that they’re so important. If you thought that unemployment was fundamentally due to people just being less skilled and has nothing to do with the fact that skills are endogenous in the sense that you can lose your skills if you’re unemployed, then these things may not be so important. But a lot of the work in microeconomics and macroeconomics over the last ten or 20 years has found that hysteresis effects are important, so I think it’s because macro models haven’t caught up to some of the developments which have happened.

VD: So what were the conclusions of your UK research?

JVR: In terms of our UK research we did find that there was a very large cost, in terms of lost output, from cutting or putting fiscal consolidation in place as early as we did in the UK. If the UK had delayed that by three years or so then it would have led to much smaller losses of output over the long run, and would have been essentially a better proposition for the UK. So at least in the UK case, delaying would have had these positive economic effects. That’s not to say that we should never consolidate; in the key scenarios we looked at it was the timing of consolidation which happened, so the key thing was that by making that consolidation happen during a period when times are hopefully better than they are now the overall economic costs in terms of unemployment and GDP would have been better than they currently have been. Now that will differ depending on which country you look at.

VD: Yes, I was going to ask you that. So timing is everything, but generally has austerity gone too far in Europe?

JVR: I think it has, in the sense that the emphasis we’ve placed in Europe on quickly trying to balance budget deficits has had the negative effect of pulling down demand and keeping Europe in a much more depressed state than it needs to be. We have multiple problems facing the world at the moment, but one of the key problems is the classical problem, the Keynesian problem of demand being simply too low and the state needing to support demand, the only actor to solve that problem is ultimately the government when the interest rates are close to zero. That, actually, is true in the US, it’s true in Japan and it’s true in Europe.

Europe has particular extra problems on top of that, and this is where the debate has got confusing. Europe does have an additional problem, which is that in the period leading up to the crisis in 2008 there were very deep structural problems between northern and southern Europe. The consumption of countries like Italy, Spain and in particular Greece was much higher than is sustainable. Even without the crisis there would have needed to be some adjustment, so a period in which there was slower growth or consumption in order to make up for the structural deficit situation they were in, which was disguised by the boom. So on top of the general economic crisis there’s a European-specific crisis, and of course that exacerbated in the European case because of the single currency, so because of the single currency within Europe there wasn’t the option in Spain, Ireland, Portugal or Greece to the big negative shock of the crisis by allowing your currency to depreciate as has happened in the UK, which has mitigated some of the costs for the UK and many other countries. Because that has been switched off the other option as happened in the US which also had a much bigger shock in some states than others (for instance Arizona had a much bigger shock than New York did), is huge fiscal transfers – so a lot of money comes from the federal government to support those places. The fiscal transfers in Europe are nothing along those levels. So you can shield or keep up demand through fiscal transfers. That, plus the weakness of the banking system as a whole, is going to push the southern European countries and peripheral countries into extreme crisis.

On top of the demand problem you have this particular problem of structural adjustment. The solution to that, as those countries have got into deep problems, massive spreads on their sovereign bonds, bank crises and so on, has basically come from bailouts brokered from the European Commission and the IMF and the bailout funds. But attached are very tough fiscal austerity conditions, and I think that the kind of mistake that’s been made is to assume that you can make all those adjustments to internal devaluation, so basically the way these countries have to adjust is to have very big wage cuts very quickly, and that’s extremely hard to do, and also causes the same spiral of cuts of demand and increasing unemployment and reduced tax revenues and so on. So I think, and this is commonly recognised now, that there has to be simultaneous movement for these countries on several fronts, doing things like recapitalising the banking system, having some medium-term fiscal consolidation plans but not as front-loaded as they currently are.

VD: Do you welcome the ECB’s decision to make unlimited purchases of government bonds in the secondary markets?

JVR: I think that’s an entirely sensible thing to do. The ECB seems to be the best-functioning pan-European organisation at the moment and it was a very good move of Draghi’s to do that. But the caveat is of course that the purchases the ECB would make are conditional on a country signing off on a bailout agreement. Of course it depends on what that bailout agreement is; if the bailout agreement is excessively tough, if it’s demanding cuts of the budget deficit far more quickly than is economically sensible, then it’s going to be self-defeating. So if a government were to sign up to that it’d reduce its sovereign bond spreads but the economy would go into freefall, and that’s what’s happening in Greece right now. You can see it very vividly. It’s reasonable for the ECB to make that action conditional on bailout, the question is what form the bailout agreement is in.

There is too great a consensus in Europe that you have to very, very quickly eliminate the structural budget deficit. I do think it’s important, and this is part of the bailout agreements, to push for structural reforms in many of the southern European countries – so to have greater flexibility in the labour markets like firing costs, have more open product markets and reducing barriers to entry there, to move more activity into the private sector. Those are all beneficial things to have, and to the extent that you can push governments into making those needed structural adjustments that’s all to the good. But those are very long-term reforms; the benefits are not going to come in 12 months or 24 months, they will come over a number of years as they did in countries that did do that sort of thing, like the UK and Germany.

VD: Then should Spain be swallowing its austerity medicine right now?

JVR: Spain has not gone and got a bailout fund or asked for this yet. The problem in Spain is that it hasn’t started properly embarking on some of these structural reforms. Italy has, for example. Italy under Monti has been a good example of a country which has started to make inroads into these necessary adjustments in terms of labour and product markets. They’ve also made some fiscal consolidation, mainly on the tax side. Spain itself needs some degree of austerity, less than the degree that many people have asked for, but it does need some plan for adjustment. Its main problem, though, is its failure to recognise the crisis in the banking system.

So what’s happening in Spain is effectively the state taking on a lot of the debts that places like Bankia and other kinds of banks and regional cajas have, so loads of bad loans, huge bad debts, mainly institutions that are fundamentally insolvent. This is the mistake Ireland made, when Ireland took on all the bad debts of banks, that’s basically what caused the sovereign debt crisis in Ireland. Exactly the same thing will happen in Spain unless some proper recognition happens of the size of the bad debt problem in Spanish banking and other institutions, and there’s a set of reforms to effectively liquidate many of these assets, former bad banks with bad assets, and unfortunately to close down a lot of the institutions which are not performing. The current plan is that there’s going to be a revelation of the state of the Spanish banking sector, but unless there’s also a plan for what to do with those bad debts, all that’ll happen is huge market panic. So I think the prime minister, Mr Rajoy, has to bring these two things together, there has to be a full set of proper stress tests and transparency over that. But at the same time, on the day that’s announced there also have to be things put in place to recapitalise some part of the system and also close down some of the underperforming loans on parts of the system, and that’s necessarily going to lead to many bond holders losing money. But that’s the nature of capitalism.

VD: So finally, John, do you see a positive future for the Eurozone?

JVR: It’s hard to be positive. I’m an optimistic person by nature, so I think there is a way through this. From an economic point of view, I think there’s a clear way through the crisis. On the demand side of things it’s a question of the timing of consolidation, and that can be done with a plan which is back-loaded rather than front-loaded. There has to be a move to a greater banking union, in terms of supervision of banks, in terms of deposit insurance which has to be done centrally as the EC is proposing. It doesn’t have to be every bank but it has to be the most important systemically. The banking reform has to happen, there has to be some way of dealing with fiscal problems. There has to be a kind of competitiveness union, to get the Lisbon Agenda back on track and do the kinds of reforms to product and open markets that are needed, and there has to be some political centralisation. If the euro is to survive the richer northern European countries are going to be subsidising the southern European countries; there has to be a way for greater oversight, for a more federal Europe. That is absolutely inevitable; it’s not going to happen overnight but there have to be some paths towards that. Crudely speaking, to allow German and Dutch and Finnish taxpayers to have the confidence that they’re not just going to bail out southern European countries who will continue with the sort of overconsumption as they did before. Primarily this is not a government problem, it’s equally a problem with the private sector, of insufficient control of the banks. That’s what happened in Ireland and Spain. But the fiscal union, the banking union, the competitiveness union and the more democratic union have to go hand in hand.

VD: John Van Reenen, thanks very much.