Article by Investment U
Can fiscal austerity boost economic growth? There’s a movement sweeping through the debt-heavy developed world that says, “Yes!” But is there any proof of this?
In January of this year, two people were talking about the same question. However, their answers were quite different. And how this question is answered will have a dramatic affect on the world’s economy for years to come…
Famed economist Joseph Stiglitz, who won the Nobel Prize in 2001 for his work on how markets work inefficiently, has gone on record to say that imposing austerity measures as countries slow towards recession is a fundamentally flawed response.
“The answer, even though they see over and over again that austerity leads to collapse of the economy, the answer over and over [from politicians] is more austerity,” Mr. Stiglitz told the Asian Financial Forum – a gathering of thousands of finance professionals, businessmen and government officials in Hong Kong.
George Osborne, Chancellor of the Exchequer of the United Kingdom, told the same forum days earlier that the United Kingdom’s fiscal austerity measures were the only way to convince the market of the UK’s economic credibility. Keep in mind these measures have been in place for over a year now while the country’s economy has tipped into recession.
“When you have a high budget deficit, if you do not have a [disciplined fiscal] plan then you will not have sustainable growth because investors will be worried about investing in your country,” said Osborne.
So that’s the debate. Here’s the question: Can austere fiscal policy boost economic growth? There’s a movement sweeping through the debt-heavy developed world that says, “Yes!” But is there any proof of this?
The Austerity Debate in Economist speak
Since the global financial crisis of 2008 to 2009, sovereign debt in the developed world has gotten out of control. There are many factors related to the financial crisis that have fueled the debt increase, from stimulus packages to lower tax revenue.
And what’s more frightening is if these issues aren’t corrected down the road, the aging populations in advanced economies will put a strain on government debt levels that will be overwhelming.
In response to the growing concern, Europe has chosen austerity. Some experts argue that austerity programs effectively reduce debt by directly targeting the cause of high debt levels – that is, government spending that’s too high or tax revenue that’s too low.
The idea, as stated by Chancellor Osborne, is that austerity will actually increase economic growth. As the Chancellor said, his argument is that commitment to fiscal austerity will increase investor confidence in the government and thus lower the interest rates charged by investors on government bonds. If lower borrowing costs for the government also reduce interest rates for us individuals and corporations, consumer spending and investment may increase, thus you get an uptick in economic output.
On the other hand, austerity has been criticized by some economists – like Mr. Stiglitz – as possibly undermining a weak recovery from the global financial crisis. Many economists agree, however, that these programs are costly to implement.
They argue that austerity policies decrease aggregate demand in the short term. This causes the economy to contract and unemployment to go up. What can be fatal is if economic output falls faster than the debt. If this is the case, the debt-to-GDP ratio can actually rise.
And then, as we have seen in the PIIGS of the Eurozone, austerity programs can be a political nightmare to implement. Citizens don’t like it:
But is there any actual data out there to see who’s right?
What the IMF Found…
Jaime Guajardo, Daniel Leigh and Andrea Pescatori of the International Monetary Fund recently studied austerity plans implemented by governments in 17 countries over the past 30 years. They tried to key in on what the government actually intended in a variety of ways. For instance, by looking at media accounts of what officials were actually saying and not just at public debt patterns. They read budget speeches, reviewed stability programs and even watched television interviews with government officials.
In order to be classified as an austerity program, the government had to hike taxes or cut spending because they viewed it as a good policy with potential long-term benefits. They tried to weed out those policies that responded to short-term economic slumps or were implemented to stop overheating. (For example, if the government believes that future economic strength may cause economic overheating and inflation, it might try to cool down domestic demand by raising taxes and lowering government spending.)
The group found a pattern where austerity caused a decrease in consumption and weakened the economy. That conclusion should be a warning to policymakers in the developed world today.
Two Years into the Austerity Craze
It has been two years since the austerity craze swept across Europe and nothing has gotten better. Growth in European GDP was negative in the last quarter of 2011. Unemployment in the entire Eurozone in February of 2012 was 10.8%. If you look at sovereign debt yields, no one believes that fiscal stability is right around the corner.
It makes sense to put in place austerity measures when the world believes you might be able to pay off your debts. But right now, there’s a new normal. Short-term interest rates are so low that you can’t use large rate reductions to offset the bad effects of budget cutting. The Eurozone becomes even more peculiar because of the euro. Countries can’t use monetary policy to stimulate growth.
Because of all this, austerity has been a negative for Europe. Budget cutting has killed growth and debt-to-GDP ratios in Europe are still increasing.
So What Should Europe Do Instead?
A lot of European countries have long-run fiscal situations that are just unsustainable and must be dealt with. And what they should do is look at the United States for the solution – but not at our dysfunctional government.
The real answer lies in the work of our independent committees (think The Bowles/Simpson Commission).
The best approach is to pass the needed budget measures now, but to phase in tax increases and spending cuts over time to give specific economies time to rebound. Economists would say, “Measures should be backloaded.”
If you look at the proposals submitted by most of the deficit commissions out there, they are for the most part specific. If you’re going to have deficit targets, you must tell everyone how you will achieve them.
And here’s how they are typically laid out:
- Disclose immediately whose taxes will be raised.
- Disclose specifically what spending will be cut.
- Specify when the measures will happen by setting a schedule or tying it specifically to certain economic indicators.
History shows that countries have been successful implementing “backloaded measures.” Here are two relatively recent examples:
- United States – In 1983, the Greenspan Commission came up with a Social Security reform package that was weighted towards the future. It included higher taxes and increases in the retirement age that would be implemented over a 30-year period. Everything has been on schedule since with little fuss.
- Sweden – In 1995, Sweden set up a program to cut its deficit by a whopping 8% of GDP by 1998. As Carl Delfeld recently wrote, it also got the job done.
It usually happens that when you pass laws, politicians really don’t want to revisit it later on. But if you go this route, it’s important to make sure there are no legislative backdoors to get out of the needed budget cuts or tax increases.
When you study austerity, the problem you run into is that you can’t control all the variables. It’s like the argument around dynamic scoring in the budgetary process. Too many random factors can occur that may account for your findings.
Policymakers cannot afford to hold the status quo while economists come up with concrete conclusions. We may never get a definitive answer. But, what needs to be done is the establishment of long-term goals and transparency to inspire confidence. If we do that, then markets will hopefully come around.
Good Investing,
Jason Jenkins
Article by Investment U
Tradervox (Dublin) – The Federal Reserve has decided to extend the current Operation Twist which was due to expire this month. In a statement given yesterday after FOMC meeting, the program has been extended with an extra $267 billion, where short term bonds are replaced with longer-term bonds to ensure interest rates on such debt are kept low. After the decision by the FOMC, the dollar dropped against most majors. The Fed also indicated the possibility of doing more if economic situation continues to deteriorate.
