Europe's Irrelevant Austerity Debate by Daniel Gros - Project Syndicate - 0 views
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But the debate about austerity and the cost of high public-debt levels misses a key point: Public debt owed to foreigners is different from debt owed to residents.
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If foreign debt matters more than public debt, the key variable requiring adjustment is the external deficit, not the fiscal deficit. A country that has a balanced current account does not need any additional foreign capital. That is why risk premiums are continuing to fall in the eurozone, despite high political uncertainty in Italy and continuing large fiscal deficits elsewhere. The peripheral countries’ external deficits are falling rapidly, thus diminishing the need for foreign financing.
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And the evidence confirms that the euro crisis is not really about sovereign debt, but about foreign debt.
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By contrast, in the case of debt owed to foreigners, higher interest rates lead to a welfare loss for the country as a whole, because the government must transfer resources abroad, which usually requires a combination of exchange-rate depreciation and a reduction in domestic expenditure.
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But austerity can never be self-defeating for the external adjustment. On the contrary, the larger the fall in domestic demand in response to a cut in government expenditure, the more imports will fall and the stronger the improvement in the current account – and thus ultimately the reduction in the risk premium – will be.
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Second, if foreign debt is the real problem, the escalating debate about the Reinhart/Rogoff results is irrelevant for the euro crisis. Countries that have their own currency, like the United Kingdom – and especially the United States, which can borrow from foreigners in dollars – do not face a direct financing constraint.
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But the eurozone’s peripheral countries simply did not have a choice: they had to reduce their deficits, because the foreign capital on which their economies were so dependent was no longer available.