Forgotten lesson

Fiscal austerity may trigger new recession in some countries, cause prolonged stagnation in some and delay economic recovery in others.

THE Great Recession had one immediate policy consequence: a global consensus that only an immediate application of strong Keynesian policies could bring the world economy back from the brink of collapse. After several decades of almost undisputed sway of monetarist ideology over economic policy-makers across the world, suddenly Keynesian ideas were back in fashion, in particular the idea that active state intervention in the form of increased state expenditure is necessary to bring a market economy out of a recession or depression. As a result, not only were governments especially in the developed capitalist countries required to spend or provide for huge amounts of money to bail out companies in trouble, but they were also actually encouraged to spend much more to provide fiscal stimuli to prevent recession.

This enthusiasm for strong fiscal intervention in the face of crisis even infected the hoary old supporter of fiscal rectitude, the International Monetary Fund (IMF). In its annual flagship World Economic Outlook which appeared in the midst of the outbreak of the crisis in September 2008, the Fund argued: Macroeconomic policies in the advanced economies should aim at supporting activity, thus helping to break the negative feedback loop between real and financial conditions, while not losing sight of inflation risks.... Discretionary fiscal stimulus can provide support to growth in the event that downside risks materialise, provided the stimulus is delivered in a timely manner, is well targeted, and does not undermine fiscal sustainability (page 34).

The G20 group of countries that set themselves up as the power lobby to run the world also declared their support for collective fiscal expansion in their early post-crisis meetings. Even bankers and large multinational company executives hailed this shift as necessary, even critical, to save global capitalism.

But rarely has an economic idea had such a brief revival. Suddenly, and so quickly as to be quite unexpected, it was over. The brief honeymoon that financial markets had with state intervention appeared to sour as soon as the banks felt strong enough (as a result of the massive bailouts they had been given and the very low interest rates that were applied everywhere) to manage without any more direct funds. And they along with other financial players turned on the source of their deliverance, increased government spending.

The attacks began first in the financial press with fears being expressed about rapidly rising government deficits and the sustainability of government debt levels. They then spread quickly to bond markets themselves, which attacked any government that was perceived as having a slightly weaker position in terms of aggregate debt levels.

A more classic case of biting the hand that has fed you would be hard to find. It turns out that of the top 10 countries whose governments saw a significant deterioration in their fiscal balances in 2008, the majority had actually been running fiscal surpluses just the year before. And for the largest of such countries the U.S. and Spain the change in fiscal situation was directly related to the large bank bailouts that had to be provided. Indeed, Spain, Mongolia, Iceland, Latvia and Turkey had all been running fiscal surpluses in 2007. It was private sector irresponsibility that created the imbalance and associated crisis in all of these countries, but in each of these cases it was the government that had to step in and save the economy as well as its most reckless banks.

What they have now got for their pains is a prolonged hammering from bond markets, which are demanding massive cuts in public expenditure that would require enormous sacrifices from their populations. So the banks are putting pressure on governments to reduce government deficits that their own actions necessitated, but in ways that preserve their own incomes and profits while imposing austerity on workers and other hapless citizens.

All this is particularly surprising because there is no theoretical or empirical basis for deciding that a particular level of public debt is more than what is acceptable, or that a particular debt trajectory is sustainable, or even that a particular level of fiscal deficit will generate so much more debt over time. All of these depend upon several other factors, none of which is likely to stay the same. So most predictions of future public debt levels in any country, whether they are pessimistic or optimistic, are equally unreliable.

As it happens, countries have had debt crises with ratios of public debt to GDP that are lower than half, and some have managed to avoid debt crises even when their public debt to GDP ratio has been more than 100 per cent for a prolonged period. The confidence of bond markets is driven not by superior knowledge or better predictive capacity but by a range of factors that are hard to pin down. Indeed, it is likely that if financial markets were to be confronted by confident governments that insisted on coordinated and positive fiscal stimuli, they would respond by accepting this and bond yields would not rise so much even for weaker deficit countries.

Focus on cut in spending

Instead of simply reiterating this obvious point and behaving accordingly, policymakers (except to some extent in the U.S.) are joining in the general argument about the need for fiscal consolidation. Nowhere is this more evident than in Europe, where even governments of surplus economies like Germany are announcing measures to control expenditure. Since deficit countries in the eurozone are being forced to engage in deep and wide-ranging cuts, and others who are not in the eurozone (like the United Kingdom and several East and Central European economies) also intend to do the same, the result is likely to be a severe negative stimulus for the European economy as a whole, which will substantially increase the likelihood of even more employment losses, material insecurities and reduction in living standards.

What is most significant is that everywhere in Europe, the focus is on cutting public spending, usually on areas that affect not just public employment but often essential or desirable social services. They also have strong negative multiplier effects on the viability of small businesses that cater to such activities. Insofar as tax increases have been mentioned, they are dominantly in the form of indirect taxes (like VAT, or value added taxes) that are regressive and raise the price of essential goods and services that fall disproportionately on lower income groups. Largely, therefore, these cuts amount to attacks on the working class, however defined.

Consider the example of just a few countries. Portugal's Socialist government has recently announced a package that includes a 5 per cent cut in the public sector wage bill and a 2 percentage point increase in VAT to 23 per cent, the highest in Europe. While the trade unions have attacked these cuts as unjust and humiliating, they are similar to measures in several other countries. In Spain, where public finances were in sound shape before the crisis and the recent deficit is entirely because of bailouts and other effects of the financial crisis, the spending cuts announced by the government have fallen dominantly on wages and public services.

The recent experience of the Baltic states shows what the impact of such measures is likely to be. These three countries have practised what has been called an internal devaluation insisting on maintaining a fixed exchange rate with the euro while shrinking the economy through sharp domestic deflationary measures. Government spending cuts have been instrumental in causing the GDP of Latvia, Lithuania and Estonia to fall by more than 20 per cent in two years, while wages in Latvia's public sector, for example, have fallen by 30 per cent. Apart from worsening quality and increasing user charges for public services, this has led to huge open unemployment and sharply falling real wages in the private sector in all these economies.

The latest and most enthusiastic kid on the block is the U.K., where the new coalition government has embraced the prospect of fiscal austerity, probably seeing it as an opportunity to enforce the greater penetration of private profit-oriented activity in all spheres of economic and social life. The cuts recently announced by Chancellor George Osborne include nearly half a million job cuts in the public sector and huge reductions in spending that will directly affect pensioners, those involved in education and a host of other socially essential or desirable areas. Remarkably, thus far there has been relatively little public opposition to these swingeing cuts in Britain, reflecting and reinforcing a national mood of resignation, self-flagellation and depression. How long such a mood will dominate over a recognition of the clear class interests that have been shown by the government is still not clear.

Quite apart from the income distribution implications of all these attempts at fiscal austerity, it is also clear that these measures are macroeconomically stupid. Most analysts agree that these spending cuts in Europe may trigger a new recession in some countries, generate prolonged stagnation or gentle decline (along the lines of the Japanese economy in the 2000s) in others, and generally have a negative impact on the chances for economic recovery in other regions. The U.S. administration has been particularly concerned about the negative impact this will have on the growth trajectory in the U.S.

Even the IMF, in its latest World Economic Outlook, has said: Fiscal consolidation typically has a contractionary effect on output. A fiscal consolidation equal to 1 per cent of GDP typically reduces GDP by about 0.5 per cent within two years and raises the unemployment rate by about 0.3 percentage point. Domestic demand consumption and investment falls by about 1 per cent (IMF WEO October 2010, page 95). It further noted that budget deficit cuts are likely to be more painful if they occur simultaneously across many countries.

So why on earth are so many (if not all) European governments rushing to engage in what is a blatantly self-destructive economic path? Partly this reflects the continued political power of finance in most countries. But it also reveals the misplaced but unfortunately common belief in each country that it can somehow export its way out of trouble. The general presumption is that external markets will provide the dynamism required to generate growth in these economies.

It takes only a little intelligence to realise that the fallacy of composition must operate in such a scenario. In other words, obviously, all countries or regions of the world cannot rely on net exports to make their own economies grow, especially if they are intent on suppressing domestic wages and demand to make their own economy more competitive. The recent Trade and Development Report 2010 from UNCTAD also shows clearly how the idea that the so-called emerging markets (like China, Russia, India and Brazil) can provide anything like an equivalent market in the global economy is simply nonsensical given current economic sizes and growth patterns. In any case, these countries are also still obsessed with exports as the engine of growth!

Clearly, the current moves to fiscal consolidation in Europe are both economically wrong-headed and socially unjust. But of course their reversal essentially depends upon political pressure. The collective lemming-like march to economic self-destruction cannot be stopped unless people everywhere stop accepting the nonsense currently being peddled about economic policy and demand more viable and fair economic alternatives.