March 2012

ECONOMICS: Austerity and growth

CannonsA vicious economic argument is raging about whether austerity measures pursued by several governments are aiding or hampering economic growth. George Mitton investigates.

Whether you call it austerity, belt-tightening or simply “cuts”, it amounts to the same thing: a government reduces its spending on things such as healthcare and defence to pay off its debts.

The motive is rational. There is a limit to how long a country can keep accumulating debts before its creditors lose confidence that they will get their money back. When creditors decide to penalise a debtor country, interest rates on its loans go up and it costs more than ever to service the country’s debts. Like Greece, the country may be brought to the brink of a default.

And yet, as countries across Europe implement budget cuts, a fiery argument rages among economists. Was it the right time, in the wake of the severest global recession in decades, to implement austerity? Or does this policy risk sabotaging economic growth at precisely the time countries most need it?

Critics of austerity gained some ammunition recently when the National Institute of Economic and Social Research, a British think tank, produced a graph that suggests the current depression in the UK will last longer than that experienced in the 1930s (the institute interprets the term recession to mean a period when output is falling or receding, while depression is a period when output is depressed below its previous peak).

Back then, economic growth fell nearly 8% and recovered to its previous peak within four years. Today, it is nearly four years since the UK entered recession in 2008 and GDP is still nearly 4% less than it was before the recession began, according to the institute’s research.

Britain is not alone. The economist Paul Krugman compared historical data from Angus Maddison, the British economist and world scholar, and the International Monetary Fund and argued that Italy is also poised to experience a longer depression than in the 1930s. Italy’s technocratic government is cutting spending to try to reassure bond markets and bring down its high borrowing costs.

Not every country is so badly affected. Germany and France are much better off than they were in the 1930s, says Krugman. Nevertheless, the fact that two of Europe’s big four economies are mired in a recession worse than the 1930s is, he says, is a powerful counterargument to the austerity advocates.

In contrast to the struggling European nations, austerity critics are likely to look to the United States, which has yet to implement an austerity agenda and where economic and employment data in recent months has been positive. According to the Bureau of Labor Statistics, total nonfarm employment rose by 243,000 in the US in January, bringing unemployment down to 8.3%, a 0.8-point decline since August.

In contrast, unemployment in the 27 nations of the European Union hit 9.9% in December, an increase of 923,000 in the preceding year, or a 0.4-point rise, according to Eurostat, the statistics division of the European Commission.

Of course, the US has taken drastic action to revive its economy in the wake of the financial crisis. Like the UK, it has used monetary stimulus – quantitative easing – to boost growth. And because it has yet to pursue austerity, the country has done little to reduce its budget deficit, a fact which is hotly debated at home.

But many people there, including former president Bill Clinton, say the country has taken the right course: delay austerity until growth is back on track. Clinton explained the point at a campus press conference in Washington, DC last year.

“In the current budget debate, there is all this discussion about how much will come from spending cuts, how much will come from tax increases. Almost nobody’s talking about one of the central points that everyone who’s analysed this situation makes... you shouldn’t do any of this until the economy is clearly recovering.”

He went on to outline a key risk attached to austerity: “[The UK] adopted this big austerity budget. And there’s a good chance that economic activity will go down so much that tax revenues will be reduced even more than spending is cut and their deficit will increase.”

Clinton’s comment goes to the heart of the austerity debate. It is undisputed that austerity hurts growth. If a government decides not to spend money on building a new hospital, that decreases economic output. The question is how much. For if the cost of the fall in output is greater than the money saved by the cut, austerity may be doing more harm than good. Austerity could even lead to the situation Clinton describes where a fall in tax revenues outweighs the saving.

The question hinges on the notion of a “multiplier”, which is usually associated with the Keynesian school of economics. Azad Zangana, a European economist at Schroders, explains: “The size of the multiplier determines how much of an impact there is through the economy. If the multiplier is greater than one, for every 1% cut in public spending, there is a greater than one-times effect on the economy, which takes time to filter through.”

The size of the various multipliers is hotly debated. According to classical economists such as Robert Barro, there is barely any multiplier effect because the multiplier is much less than one. These economists argue that any pound the government withdraws from public spending is largely matched by investment from the private sector.

Yet Richard Kahn, the British economist who along with Keynes is credited with developing the multiplier concept, argued that public spending has an effect on the economy that is almost double the size of the initial investment, because of knock-on effects such as creating jobs. In reverse, this means a budget cut hits the economy twice as hard.

“According to the Office for Budget Responsibility and, I think, most economists’ forecasts, currently the multipliers are below one, so the impact tends to be smaller than the cut in the medium term,” says Zangana.

He admits there is a potential problem with the models used to estimate the multipliers, which is that they assume there is room for monetary stimulus to offset the effects of the cuts. Interest rates are now at rock-bottom levels, which means there is no room for such stimulus. However, he still believes the austerity regime can achieve its targets.

“The austerity agenda is clearly hurting growth,” he says. “But this is a short-term issue. Once you have cut the spending in year one, you may not have to cut the spending in year two. You don’t have another fall-off in growth in the second and third year, in theory.

“Beyond three to four years, the impact of the cuts disappear and what is left is an economy that is usually more nimble, in the sense that it has a smaller public sector and more room for the private sector to manoeuvre.”

Of course, Krugman and others from the Keynesian school disagree.

©2012 funds europe