In memory of Dr. Andreas Höfert

Maximizing austerity is not optimizing austerity

Debt-ridden countries in Europe are fiercely debating the best strategy to free themselves: austerity, which might hurt growth; or stimulus, which might delay fiscal discipline indefinite future. As usual, escaping a dilemma like this requires more finesse than just taking sides.

Spanish Prime Minister, Mariano Rajoy, and his Italian counterpart, Mario Monti, both announced recently that it would be very difficult for them to fulfill the deficit-reduction targets agreed under the European fiscal compact. Market participants didn’t like it, which helped push-up interest on Spanish and Italian bonds and opened a new chapter in the European debt crisis.

On paper, closing the gap between Spain’s current budget deficit of 8.5% and its target of 5.3% should cost around 32 billion euros, or 3.2% of the country’s roughly one-trillion-euro GDP. But Spanish economist and London School of Economics Professor Luis Garicano recently made a sobering back-of-the-envelope calculation, as reported in El País. The negative effects of austerity on Spain’s GDP will decrease the government’s income from taxes while driving up spending, especially on unemployment benefits. In the end, Garicano estimates that the country will need between 53 and 64 billion euros to achieve its target. Those numbers seem out of reach, at least in the short run.

This more realistic assessment suggests that the ambitious deficit-reduction targets in Spain, Italy and many other European countries are not credible. So why have they even been announced?

I see a fundamental mistrust between European governments and market participants, a tension between what politicians say and how investors react. This mistrust generates conflicting interests similar to those of the so called “prisoner’s dilemma,” a popular puzzle from game theory.

The prisoner’s dilemma goes like this. The police catch two suspected criminals. Investigators tell them that if one of them confesses while the other stays quiet, the talker will go free and his accomplice will get a 10-year sentence. If both confess, they will each get five years in jail. But if they both refuse to talk, they will each face prison terms of only one year. Studies show that despite the (collective) advantages of cooperating to stonewall the police, individuals see a decisive incentive to confess – perhaps because they don’t trust their accomplices not to betray them.

This dynamic can shed some light on the austerity measures announced by European governments and investors’ attitudes toward such announcements. The best collective outcome would be for a government to announce credible austerity measures and for investors to show confidence that the government will successfully implement such measures. However, when investors question a government’s ability to deliver, it can start to look like a better deal for a government not to deliver: If it is going to suffer from the markets’ wrath anyway, it may as well not suffer under stringent austerity as well.

And in fact, governments rarely deliver on their deficit-reduction announcements. Investors know this, and hence they rarely believe politicians. This in turn pushes politicians to try and boost their credibility by announcing extreme measures – which in the end they cannot implement. Like in the prisoner’s dilemma, these “betrayals” produce a suboptimal outcome, where governments announce extreme but unworkable measures and market participants punish them for it.

This mistrust between governments and market participants is, in my view, yet another hindrance to solving or even mitigating the European sovereign debt crisis. An initial piece of advice for politicians would be to announce realistic instead of extreme debt-reduction objectives, and then – of course – to stick to them.