Debating Conundrums at Davos: Is Austerity the Only Way?

[Editor’s note: the following is a cross post that originally appeared on Wall St. Cheat Sheet.]

In a sense, there was nothing really new at the past week’s meeting of the World Economic Forum at Davos: finding a practical solution to the national debts crisis is the problem, and the consensus solution could make that problem worse. Debating the situation amounted to little more than tweaking it around the edges, because no economic theory – left or right – has a clear answer, now that the problem has gone this far.

The governments of several eurozone countries, mostly but not all bordering the Mediterranean, have greatly overspent during the last decade and have been borrowing gigantic amounts of money to pay for it, by issuing bonds that they now can’t pay back.

Private banks and finance ministries of other countries who bought the bonds are now exposed as well, and fears are that this situation could spread like a virus, if full defaults are allowed. That is the basic problem, but the solution – austerity – could make it far worse, hence the all-consuming debate at the meeting.

There is little debate that the optimal way for a debtor country to get out of trouble is to grow its economy out of it, so that tax revenues would be sufficient to pay off debts. But that option is not available when the debtor country must borrow simply to service its previous debts and pay current bills, and especially if part of the borrowed money is spent in new ways, all of which happened in this situation.

And if that were not enough, the world recession which began in 2008, pretty much assured that the growth-only option was moot, but at some point it must work or solving the problem permanently will be impossible.

Further, eurozone members can’t make their own countercyclical monetary policies, nor do they have central banks, per se, to loan their governments money. This dilemma has prompted Greece to flirt with the idea of pulling out from use of the euro altogether.

This vicious circle [has prompted] bailouts which have their own price, and that is almost always some form of austerity in which the debtor must severely cut back spending, and also raise taxes. Economists of different persuasions can argue over whether cutting government spending (and involvement) helps or hurts an economic recovery, but few would say that raising or creating new taxes could be helpful.

Increasing tax rates beyond some point typically results in lowering, not raising revenues, and new taxes can lead to new types of evasions, including emigration of persons and companies. None of these measures encourage consumers to go out and buy refrigerators, either.

Some Davos participants, such as U.S. Treasury Secretary Timothy Geithner and IMF head Christine Lagarde, were of the view that each debtor case is different and their cures should be “tailor-made,” as she observed. Geithner worried aloud that the austerity measures could lead to a recessionary “cycle.”

Although a majority of Davos attendees agreed that debtors’ budget deficits must be curtailed, dissention arose over short term measures such as austerity, and longer term remedies such as extending debt maturities and lower interest rates on the bonds.

Proximity to debtors and exposure to their debts made a difference: Germany, whose private banks are quite exposed, demanded strict austerity, while the U.S. and the U.K. were more patient, although the latter two were continuing to reject extending help until more comes from the eurozone. Ms. Lagarde said that the IMF is reinforcing a “firewall” financial rescue fund made up of funds donated from eurozone members. She wants to raise hundreds of billions of dollars to that end, as she said that austerity is only a part of the solution.

To accent her appeals, she brought along a designer handbag in which to collect the funds; it wasn’t immediately clear how many billions went into the bag.

IMF Chief Christine Lagarde

(Front page photo credit: Christian Hartmann/Reuters)