Proof That Austerity Does Not Work in a Recovering Economy

austerity

austerity (Photo credit:401kcalculator.org)

Economics is as much about timing and conditions as strategy and policy. Trying to implement austerity measures during a recession is tantamount to trying to kick a field goal in a 60 mile per hour headwind. There’s a time and place for virtually every economic policy known to man. The key is implementing the right plan at the right time.

For all of the Republican “cut-spending” supporters out there, what you have happening right now in Europe is the best possible proof that austerity does not work in a fragile economy.

Europe has enacted strict austerity controls on just about everyone in attempts to get their spiraling debt problems under control. They’ve endured the pain of layoffs, wage cuts and tax increases designed to bring government debt under control.

So what happened to the success of the bold, conservative austerity plan? Where’s the “bang for the reduced buck”, so to speak?

Far from falling, debt burdens are rising fastest in European countries that have enacted the most draconian austerity programs, according to The Associated Press’ Global Economy Tracker, which monitors the performance of 30 major economies.

The numbers that are occurring is black and white proof for the analysts say: Austerity isn’t just painful. It’s counterproductive and it makes a country’s debt load grow not shrink.

The biggest fear is that the cutbacks will cause Europe to sink into a self-defeating spiral: Higher debt leads to harsher spending cuts, growing social instability and deeper debt problems as unemployment increases causing fewer tax collections for operating capital. Governments inevitably find it even harder to pay their bills…..and on, and on.

You want pain? Portugal’s unemployment rate hit a record 14 percent at the end of last year. Ireland’s economy contracted a worse-than-expected 1.9 percent in the July-September quarter of 2011. And Greece reported that its already basket-case economy shrank 7 percent in the October-December quarter of last year.

Under a deal approved Tuesday by the 17 countries that use the euro and the International Monetary Fund, Greece will get a $172 billion bailout in exchange for accepting another dose of austerity that includes laying off 15,000 civil servants and slashing the minimum wage by 22 percent.

A modicum of progress has been made in the bond market, where interest rates on government bonds have declined making it cheaper for some indebted countries to borrow.

But the drop in rates can not last. And the lower rates probably have less to do with budget cutting than with what the countries’ central banks are doing: They’re buying bonds, which pushes down rates, and providing low-cost loans for banks to do the same.

And borrowing costs haven’t eased across the entire 17-country euro zone: The yield on Portugal’s 2-year government note is near a painful 13 percent, up from under 5 percent a year ago.

The best way to compare debt burdens among countries is to look at the debt as a percentage of gross domestic product. GDP is the broadest gauge of total economic output. When debt exceeds 90 percent of GDP it’s considered bad for an economy’s health.

Here’s a breakdown on how the countries that imposed austerity to slash costs have actually ended up with bigger debt problems:

  • Portugal cut pensions, reduced public servants’ wages and raised taxes starting in 2010. Yet in the third quarter of 2011, government debt equaled 110 percent of GDP. That was up from 91 percent a year earlier.
  • In Ireland, middle-class wages have been reduced 15 percent and the sales tax boosted to 23 percent (the highest in the European Union). But its debt amounted to 105 percent of economic output in the third quarter of last year; a year earlier, it was 88 percent.
  • In Britain, Prime Minister David Cameron staked his political future on his austerity plan. Government debt ratios, though, reached 80 percent in third-quarter 2011, up from 74 percent a year earlier. And Moody’s this month cut its outlook on Britain’s prized AAA credit rating from “stable” to “negative.”
  • In Greece, two years of austerity programs have devastated the economy and triggered riots. Still, the government’s debt equaled an alarming 159 percent of the country’s GDP in the July-September quarter of 2011. That was up from 139 percent a year earlier.
  • Norway, by contrast, has a strong economy and has avoided painful austerity measures. And its debts dropped to 39 percent of GDP in the third quarter, from 43.5 percent in the same quarter of 2010.

Economic conditions have deteriorated to the point that economists question whether the latest rescue plan can have any positive effect over the long run.

“The Greek debt deal puts off the day of reckoning,” says Eswar Prasad, senior professor of trade policy at Cornell University. “We can breathe a sigh of relief for the next few weeks. But a lot of trouble is still coming.”

Simple math explains why austerity can worsen government debt: If spending cuts and tax increases tilt a country into recession, GDP shrinks. So debt doesn’t even have to grow to become a bigger burden on a contracting economy.

You can’t fix the debt-to-GDP problem if GDP is falling, and it looks as though the British economy is already headed back to a full-blown recession as just published figures show that growth for all of 2011 was an anemic 0.9%.

Recession in and of itself adds strains to the budget. Tax revenue dries up. Spending on unemployment benefits and other social services rises, services become less efficient and it begins to feed on itself.

Naturally bond investors tend to favor austerity programs, and here’s why: The narrower the gap between what a government spends and what it collects in taxes, the likelier it will repay its debts. Countries that strive to balance their budgets are rewarded with lower interest rates on their debt.

But the bond-market exuberance will not last.

Olivier Blanchard, chief economist at the International Monetary Fund, has reported that bond investors often rebel against austerity, once they realize that government cutbacks can squeeze growth and cause debt burdens to rise.

“There’s no doubt that the strategies pursued in Greece, Portugal and Ireland have contributed to a dramatic increase in those countries’ overall debt burdens,” says Simon Tilford, chief economist at the Centre for European Reform in London. Tilford adds, “strengthening public finances is a marathon, not a sprint, and it can only take place across a backdrop of reasonably healthy economic activity.”

The United States is taking the marathon approach, putting off serious budget cuts until the economy is stronger. Of course the conservative mantra, when there is a Democrat in the White House, is always cut spending. The area of those cuts is generally in the non-defense realm and from there the arguments divide between party lines.

What Europe and America need, is not austerity but economic reforms. I personally still do not understand why President Obama did not take the Simpson-Bowles Commissions’ recommendations and run with them. It could very well prove to be his undoing, but we will not know until November of this year.

I have advanced my own package of economic reforms that would not only deal with the current deficit in a meaningful way and leads to an eventual significant reduction in the overall government debt, but would also allow the U.S. economy necessary monetary resources to stimulate real growth in long-term construction and manufacturing.

My package of economic stratagem is referred to throughout the archives of this blog as the One-Penny-Solution. Yes, it would work just as well for Europe as the U.S. But partisan politics has taken on a life of its own as politicians seek to be in the elite club that gets to literally play by its own rules – The U.S. Congress.

As for Europe, most analysts suggest that the outlook is hopeless for Greece. Researchers estimate that Greece would have to turn its annual budget deficit, now about 5 percent of GDP before debt payments, into a daunting surplus of around 30 percent of GDP to return to financial health.

The only way out, according to the University of Maryland’s Peter Morici says, is a breakup of the euro zone. Weak countries like Greece and Portugal must abandon the euro and reintroduce their old, less valuable currencies. The return of the weak Greek drachma and Portuguese escudo would make Greek and Portuguese products less expensive in foreign markets and allow them to get a rejuvenating economic boost from growing exports.

The alternative, he says, is deepening pain and social instability.

The stakes are enormous. Unemployment could easily sky-rocket above 30 percent in Greece for years. With the government having no real means to ease the pain, revolutionary conditions and social unrest will prevail.

As a result, the EU and for that matter, U.S. policymakers, seem determined to delay the inevitable pain, even though a little now could very well avoid a lot later.

And in the U.S., with an election cycle every two years, it appears that U.S. politicians are content with blaming the other side and just trying to make it through the next election.

 

Harvey Gold

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  1 comment for “Proof That Austerity Does Not Work in a Recovering Economy

  1. Mechasr
    February 24, 2012 at 10:02 am

    Yes, if Greece and Portugal return to their old currencies it will make exports from those countries less expensive in other countries which should increase demand for their product and therefor increase demand for labor and improve their gdp.

    Also, it will make imports into those countries more expensive, boosting demand for domestic products which, again, should increase demand for their product and therefor increase demand for labor and improve their gdp.

    Doing that imposes a sort of natural austerity in that imports become more expensive, so people will be able to afford less. But it’s an organic austerity induced by natural market forces. And rather than reduce employment and the tax base in those countries it should do just the opposite, which is exactly what Greece and Portugal want.

    Euros would become more expensive relative to drachmas and escudo. Maybe that’s not so great for foreign bond holders who want to be paid back in euros; on the other hand, maybe it’s good for them because the economies will get stronger and will be selling exports for euros which can be used to pay the bonds. In any case it’s probably better for everyone else.

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