Learning About Growth from Austerity
— May 18, 2013
By A. Michael Spence
This should not be surprising. Accumulating excessive debt usually entails moving some part of domestic aggregate demand forward in time, so the exit from that debt must include more savings and diminished demand. The negative shock adversely impacts the non-tradable sector, which is large (roughly two-thirds of an advanced economy) and wholly dependent on domestic demand. As a result, growth and employment rates fall during the deleveraging period.
In an open economy, deleveraging does not necessarily impair the tradable sector so thoroughly. But, even in such an economy, years of debt-fueled domestic demand may produce a loss of competitiveness and structural distortions. And the crises that often divide the leveraging and deleveraging phases cause additional balance-sheet damage and prolong the healing process.
Thanks in part to research by Reinhart and Rogoff, we know that excessive leverage is unsustainable, and that restoring balance takes time. As a result, questions and doubts remain about an eventual return to the pre-crisis trend line for GDP, and especially for employment.
What this line of research explicitly does not tell us is that deleveraging will restore growth by itself. No one believes that fiscal balance is the whole growth model anywhere.
Read full article as published in Project Syndicate
A. Michael Spence is the William R. Berkley Professor in Economics & Business.