In 2011, the case for austerity was made across Europe and North America. Austerity was seen as the way in which nations could put their houses in order. Restraint was to be the order of the day as a prelude to paying down the mountains of debt that nations had accumulated in bailing out the financial system at the start of the present financial crisis. Some countries, such as Ireland, embraced the austerity agenda at an early stage. Others, such as Greece and Spain, have had it thrust upon them by a combination of events, bullying by other nations, and as a condition of financial support imposed by international bodies, especially the IMF. The purpose of this piece is to consider whether austerity will work in the longer term.
Perhaps it is worth starting by stating what we mean by austerity. There is no doubt that austerity means fiscal contraction, either by reducing public expenditures, increasing taxes, or a combination of both. However, in the light of this, we ought not to exclude monetary policy and exchange rate policy. Whilst many nations have been subject to fiscal contraction in 2011, there has also been a corresponding monetary expansion at the same time. By keeping interest rates at an historically low level, and by pumping domestic money supply through QE, the monetary stance of most European and North American governments has been expansionary. Exchange rates have also been used as an adjustment mechanism to accommodate fiscal contraction, although in less a deliberate way. Taken together, the typical path to austerity in 2011 would often be a sharp fiscal contraction, accompanied by a monetary expansion, along with a softening of the exchange rate.
This policy has been used in differently over 2011. The most expansionary economy of the group – that of the United States – has seen a combination of fiscal expansion, monetary expansion, and a reasonably static exchange rate over 2011. This has resulted in US GDP growth of about 1.8% in 2011. The least expansionary of the group – that of the Eurozone – has seen a combination of fiscal contraction, initially a tight monetary contraction followed by a little loosening of monetary policy, and an exchange rate that has fallen in Dollar terms. This has resulted in Eurozone GDP growth of 1.6% in 2011. The UK occupies a middle stance, with a fiscal contraction, a monetary expansion, and an exchange rate that is competitive in both Dollar and Euro terms. Even so, the UK should manage GDP growth of about 0.9% for 2011. This variety of approaches to austerity gives us some initial readings to indicate the usefulness of the policy.
The argument against austerity is that it chokes growth. This has two unhelpful consequences. The first is that it makes the deficit worse than originally planned as the cost of social benefits rises and the tax take falls. These are the ‘automatic stabilisers’. The UK, Ireland and Spain appear to be suffering from this problem as the tax bases of these countries – which were heavily dependent upon a property boom – have melted away. The second consequence is more technical. As GDP falls and the deficit fails to keep pace, the Deficit-to-GDP ratio will rise, making more severe austerity needed in following years. It is likely that Greece has reached that position now. It would appear that Spain, which will miss it’s deficit reduction targets because of the automatic stabilisers, is likely to head into this position in 2012. From the perspective of the Eurozone, it is difficult to see from where any growth may come in 2012. Even Germany, the powerhouse of the Eurozone, could be heading towards a period of sluggish growth. This would suggest that austerity has choked growth in 2011.
And yet, is there an alternative? We are often told that a nation cannot borrow its way out of a recession. I’m afraid that we beg to differ. The US in 2011 has borrowed it way out of recession, and it would appear that the UK is about to do so for 2012. In a surprising change of direction, the UK chancellor announced late in 2011 that a programme of public infrastructure works would be initiated in 2012. This is exactly the type of fiscal expansion that we believe is needed in the UK, if not throughout Europe and North America. What is also interesting is that the UK works are to be part funded by the public sector, but the majority are to be funded by the idle balances within the UK financial sector. The policy of putting unproductive balances in the money economy to work on productive assets in the real economy has to be commended. We shall see if this has an impact in 2012 by the UK having an easier recession that the rest of our trading partners.
It is a shame that the US has abandoned the stance held in 2011 and appears to be embracing austerity for 2012 with both a fiscal contraction and a potential monetary contraction. The US seems plagued by populist politicians who don’t appear to understand the basic fundamentals of monetary policy. In a Presidential Election year, this simplistic approach is likely to just cause more problems for the American economy. If our model is right, and if the populists were to gain the upper hand, then the outlook for the US could be quite gloomy. However, we can all hope that common sense will prevail and that, even if there is a mild fiscal tightening, the Fed will continue the policy of monetary expansion.
To return to our original question, does austerity work? It does in that it helps to calm the financial markets and it gives the speculators a different target for their attention, such as gold. However, it also chokes growth and, by doing so, also reduces its long term effectiveness. Fortunately for those of us in the UK, austerity has been abandoned for 2012. If the US and the Eurozone embraces that agenda whilst the UK doesn’t, then we should continue to have quite a good recession.