The Math on Greek Austerity

The general shape of the challenges facing Greece are pretty well-known, but it’s worth boring deeper into the issue with Rebecca Wilder, which highlights the extent to which the whole plan for the Eurozone looks like wishful thinking:


Look at the government’s period budget constraint (left), where the lower-case letters “d” and “p” stand for the debt and primary deficit as a share of GDP, respectively. r is the nominal interest rate, and (1+g) is the rate of NOMINAL GDP growth (including price appreciation). (Email me if you want the algebra.)

When Greece starts dropping p (the primary deficit), the fundamentals of the economy (i.e., nominal gdp growth (1+g)) must be robust enough to prevent a surging debt burden. And here’s the cycle: to drop the primary deficit, it does so by reducing G and raising T, which drags Y (as of Y = C + I + G + Ex – Im) and growth of Y, (1+g), since export growth is unlikely to be there to offset the decline in private spending; these effects then flow back to the primary deficit to raise p.

And likewise, only under the circumstances of heroic export growth can the government reduce its fiscal deficit to 3% WITHOUT the private sector levering up their balance sheets and contributing to a larger default risk (of the depressionary type). I’m confused.

All of which I take to indicate that the European Central Bank desperately needs to take action to raise the Eurozone’s nominal GDP growth level. The ECB’s policy stance has been much less expansionary than the Fed’s, even though the need for monetary action is probably greater over there.