Why the eurozone is busy going backwards
Austerity plans all over the world – and especially in Europe – are worsening government finances while inflicting misery, writes Michael Collins.
“Pain. But no gain” was how The Independent newspaper of the UK summed up the grim news on the country’s economy one day late last year.
Unemployment had jumped, the Bank of England had slashed growth forecasts, and the UK Treasury had forecast that the sluggish economy and rising joblessness would boost government debt beyond previously projected levels.
“Pain. But going backwards” would have been a more accurate (though less lyrical) assessment of the austerity squeeze of David Cameron’s government.
The coalition slashed spending and raised taxes to tackle a budget deficit that stood at 8.5 per cent of the gross domestic product (GDP) in 2011 and to lower government debt from 73 per cent of GDP – even though the country was under no pressure from bond investors to do so.
“Those who argue that dealing with our deficit and promoting growth are somehow alternatives are wrong,” Cameron said in Davos in 2011.
The economic news out last November showed otherwise – as has data since.
The jobless rate surged to a 15-year high of 8.3 per cent in the third quarter (2.6 million out of work). The Bank of England cut the growth forecast to just 0.9 per cent for the year to June 2012.
The Office of Budget Responsibility revealed that net public borrowing targets had, in effect, been blown three years off course and past Labour’s 2010 predicted peak.
Austerity is hardly a political-winning strategy because it prompted two million public servants to strike on 30 November 2011 – the UK’s biggest industrial action for at least 30 years.
The UK’s experience is another testament to how austerity plans all over the world are worsening government finances while inflicting misery; the fiscal compact 25 European countries signed up to on 30 January 2012 will legally hinder them from using fiscal stimulus to spur their economies.
They prove that Keynesians have a better recipe for repairing government finances over the medium term. The big flaw of Keynesian economics in practice is more subtle though.
Reality versus ideology
The Keynesian medicine for tough times is the counterintuitive solution of boosting government spending because economic growth and some inflation are the best ways to prune public deficits and debt.
More people in jobs means higher tax revenue and lower spending on social security – the opposite of what austerity does.
Austerity is even more pointless if a country’s trading partners are inflicting the same pain, or monetary policy can provide no help for an economy in the form of reduced interest rates or a lower exchange rate.
The terms imposed on Greece as part of its rescue packages included such fierce spending cuts and tax increases that they have made the country almost ungovernable while ruining its economy – Greece’s GDP shrivelled 5.2 per cent in the year to September 2011, manufacturing slumped 15.5 per cent in December from a year earlier, and unemployment is already 20.9 per cent.
At the same time, these austerity policies have destroyed government finances. Greece’s ratio of government debt to GDP has soared from 110 per cent in 2010 to about 160 per cent.
Once this ratio reaches 100 per cent, it’s difficult for it to decline unless a country’s economy is growing at a faster pace than the average interest rate on government debt.
Since austerity crushes growth, its adherents appear ideological as they stress how cutting government spending will give business the confidence to invest.
Nobelprize winning economist Paul Krugman dismisses proponents of austerity for believing in the “confidence fairy”.
Bond investors and rating agencies took little time to work out that austerity damages economies and worsens government debt positions.
This is why we are witnessing the vicious cycle of rising bond yields damaging government finances leading to higher yields, which prompts a rating downgrade, leading to higher yields and so on.
So austerity can lay claim to bringing on the eurozone debt crisis.
A columnist in The Telegraph of the UK has labelled Germany’s Finance Minister Wolfgang Schauble as the “most dangerous man in the world” for his push to enforce “a reactionary synchronised tightening” on Europe’s sick economies.
Flawed comebacks
Critics of Keynesian solutions cite examples of when economies grew through austerity packages. But usually the circumstances differ from today’s (and some even question the stats that prove economies grew under austerity).
Economists at the International Monetary Fund recently studied 173 episodes over the past 30 years when 17 advanced economies took steps to fix government finances.
While the study’s conclusion was that austerity boosted unemployment (and hence failed to mend public finances), Ireland in 1987 and Finland and Italy in 1992 coped under austerity.
This was because large currency depreciations boosted net exports, or lower interest rates supported consumption and investment.
“Unfortunately, these pain relievers are not easy to come by in today’s environment,” the authors said.
The critics of fiscal stimulus say the US government’s US$780 billion package failed to reignite the US economy, even if it helped avoid a depression.
It’s true the US economy has only wobbled along since the stimulus was approved in 2009. The problem was, though, that the package was never big enough and was poorly designed.
It was about half the size needed and contained incremental tax cuts and only glacial increases in public works. Any good it did was offset by reduced spending by state governments.
The Australian Government’s response to the global financial crisis in late 2008 and 2009 is an example of a well-constructed stimulus package.
The “go hard, go early, go household” cash and building stimulus propped up the economy and meant the Government undershot its own debt forecasts.
The Federal Government’s debt to GDP was only 7.7 per cent in 2011. (To those who think China saved Australia, authorities in Beijing kept China going with a stimulus package worth 16 per cent of GDP.)
One worry now for the Australian economy is that the Government is wedded to having a surplus in 2012-13. This will mean sizeable cuts to government spending, estimated at $11.5 billion over four years.
At least, the Reserve Bank of Australia has scope to cut interest rates to keep the economy going.
Big spenders
Advocates of Keynesian economics probably feel vindicated by what’s happened in recent years. But there is one flaw to how Keynesian economics is practised.
The flipside to Keynesian economics is that during good times governments should run surpluses and reduce debt to curb inflationary pressures. If they do this, they save their firepower for tough times. The problem is this tends not to happen.
The US, UK, France, Italy and Greece are guilty of running structural deficits during the good times leading up to 2008 (though Ireland and Spain ran budget surpluses before 2008 and had reduced government debt to between 30 per cent and 40 per cent of GDP – the real cause of the eurozone debt crisis is the current account imbalances of countries on a fixed-currency regime).
France – with its generous social security – last posted a budget surplus in 1973. That’s not usual for Europe.
In aggregate, the countries in the eurozone have been in deficit for the past 40 years. The US government under President George Bush thought it could wage trillion-dollar wars while reducing tax rates for the wealthy.
These governments are in trouble now because they had to bail out banks and other industries and boost social security after Lehman Brothers collapsed in 2008.
The US Federal Government’s deficit in 2011 was about 9.6 per cent of GDP – its ratio of government debt to GDP at 73 per cent. France’s Government’s shortfall was about 5.9 per cent of GDP in 2011, while its ratio of government debt to GDP was 81 per cent.
Australia could afford stimulus in 2008 and 2009 because government debt was low – thanks in no small way to the previous government’s asset sales (rather than to any impressive spending discipline).
When the good times return, that’s when it’s time to demand prudence from governments.
Not now. Even Cameron’s government is realising, sort of, that austerity is a self-fulfilling prophecy.
By the end of November 2011, it was talking of a plan to invest in infrastructure to avoid a recession, but further squeezing the public sector and the poor to do so.
Michael Collins is the investment commentator at Fidelity.
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