Why “Austerity” Failed in Greece: Testing the Validity of Macro-Economic Models

Abstract

During the Euro Crisis which began in 2009 and is still continuing in 2015, Greece provided an interesting case of an empirical test of some macro-economic theories—particularly the theory underpinning the European Union (EU) policy of “austerity”. Fiscal austerity had been imposed upon the Greek governments as the price of EU bailout of bankrupt Greece. But after five years, the EU austerity policy was judged by many as a failure, and Greece continued to struggle at the bottom of a depression. Underlying the austerity policies, there was a macro-economic model called the Polak model. We examine whether or not this model was valid in the Greek economic context. Identifying the conceptual model underlying economic policy is important to clarify the validity or the invalidity of the model assumptions upon which a policy rests. We compare the macro-economic Polak model to an alternative model of the Greek fiscal crisis as “disequilibrium-pricing” in financial markets. An empirically invalid model can suggest bad policy, which may not solve an economic problem but can even deepen a crisis. An empirically valid model can provide a realistic basis for formulating effective policy.