Austerity: home grown vs. foreign

With the recent defeat of the left-wing party that enacted the austerity program in Greece, numerous are those who claim that the end of austerity has arrived. Personally, I see something different. What I see is the story of “homegrown institutions” vs “institutions imposed by foreigners”.

The austerity plan applied in Greece was imposed from outside Greek society. In Greece, it is Germany that bears the blame entirely. As Albrecth Ritschl of the LSE has emphasized, Germany was the biggest debt transgressor of the 20th century and lived a “greek” lifestyle sustained by credit for many years. It’s hard to blame the Greeks for thinking that the Germans are not ideally suited to tell them what to do.

Still, with record levels of public debt to GDP and spending levels with endemic growth, its hard to do anything else than cut and liberalize. Then why does austerity backfire? Its a question of “endogenous” versus “exogenous” institutions.

The success of vast institutional reforms (privatization, deregulation and spending cuts) is a function of these reforms in relationship with indigenous agents. The former institutional setting was linked to local agents who formed this setting to reflect their respective interests. Any reform imposed from outside ignores the issue of credibility and workability with these local agents. The new set of institutions – even if it is factually better to attain more desirable outcomes – generates less adhesion. In fact, imposing reforms from abroad is likely to create a greater cohesion between interest groups in favour of the status quo.

By imposing austerity from Brussels and Berlin, the members of the European Union have vastly overestimated their capacity to generate long term growth and underestimated the role of internally driven change to creating prosperity. Politically and economically, it would have made more sense to exclude Greece from the Euro zone and let them adopt the measures necessary in a manner that is acceptable to the different voters in Greece.

Recently, Alberto Alesina and Francesco Giavazzi asserted that “how” is austerity done matters as much as “how much” austerity is applied. Maybe we should propose to add “by whom” is it applied to complete their discussion.

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