Austerity vs. Deficits, Part 1

Austerity programs or stimulus -- keep your money out of countries in or recovering from recessions.
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This is Part 1 of a two-part series. Read Part 2 here.

NEW YORK (

TheStreet

) -- We hear that we need to run government deficits to create jobs. At the same time, there are fears that the mounting government debt will place such a burden on future generations they will never "get out from under." Below, I consider both approaches and how they apply to four countries: Greece, Spain, the U.K. and the U.S.

The Theories

The stimulus argument is as follows:

Spending creates jobs;

If the private sector is not spending enough to keep unemployment low, increased government expenditures, lower taxes, or lower interest rates can be used to lower unemployment;

However, there are times when lower taxes and/or interest rates will not induce more spending. Why? Because individuals and business are worried about the future. In these circumstances, only increased government spending will create jobs.

The austerity argument is not quite as straightforward. It is all about confidence. For example, Jean-Claude Trichet, president of the European Central Bank, said in June that "the idea that austerity measures could trigger stagnation is incorrect....a credible fiscal-consolidation plan will restore confidence and foster economic recovery." The argument is that if consumer demand is depressed, an austerity package could reduce fear and get people to spend more.

1

Research

The International Monetary Fund (IMF) just completed a study of fiscal actions taken to reduce government deficits in 15 advanced countries in the 1980-2009 period. The key findings:

A fiscal consolidation equivalent to 1% of GDP leads on average to a 0.5% decline in GDP after two years, and to an increase of 0.3 percentage points in the unemployment rate. Declines in interest rates, which also weakened countries' exchange rates, help explain why GDP did not decline even more sharply. 2

The IMF research is the most comprehensive work on the subject. Despite this, questions remain, in part because the "Austerity" supporters are not all that clear on what they mean by the term.

Current Experiments

The global recession provides rich data to explore the stimulus/austerity approaches. The actions of Greece, Spain and the U.K. are investigated below. In the second article in this two-part series, the U.S. case will be examined and overall conclusions will presented.

The EUR (€) Countries

While the U.K. and U.S. can print money, Greece and Spain cannot. They are part of the European group of countries where the currency for all is the EUR (€). As a consequence, they cannot "print money". They lack their own Central Bank to buy up (monetize) their government debt. What they can spend is totally dependent on their revenues and what they can borrow. Sloppy financial management coupled with lower revenues and higher expenditures resulting from the global recession put both Greece and Spain in a bind. Other EUR members forced these two countries to adopt "austerity programs" enforced by IMF staff.

a. Greece

The Greek government got in trouble because of its debt (133% of GDP in 2010) and the resulting amortization problems it faced. In 2009, the government needed to borrow $96.7 billion, and of that amount, $41.9 billion was for debt amortization. Suddenly, Greece had a real problem, and lenders were not forthcoming. Other EUR members were not happy. But they had to do something. The EUR countries and the IMF developed a financial bailout package for the Greek government. Under it, funds would be made available in tranches, as the government reached defined austerity targets. Table 1 provides details on how much the EUR countries and the IMF contributed to the bailout.

In return, the Greek government announced a plan to reduce its deficit to less than 3% of GDP by 2012.

3

As plan details became available, numerous worker strikes occurred. In April, Standard & Poor's downgraded the credit rating of Greece to junk status. Table 2 provides projections made by the staff of the IMF for future years. The IMF staff does not believe Greece can get its deficit below 3% of GDP until 2014.

From joint IMF/EU/Greek estimates, the imposed austerity plan will not be providing enough confidence to turn the country around. In fact, as Table 2 indicates, as the government budget deficit falls, the unemployment rate increases. If the IMF research reported on above is to be believed, the government deficit reduction should result in an unemployment increase of 3.3 percentage points.

b. Spain

Spain's situation is quite different. Spain does not have the overwhelming debt problem facing Greece (Spain's government debt to GDP ratio was 53% in 2009). However, its unemployment rate, already high at 11.3% in 2008, soared to 18% in 2009. Its government stimulus package resulted in a government deficit amounting to 11.2% of GDP in 2009. Like Greece, the Spanish government, under pressure from other EUR countries and the IMF, announced an austerity package with the goal of reducing the government deficit to 3% of GDP by 2013. Table 3 provides the IMF's projections.

The IMF does not believe Spain will attain the 3% deficit goal by 2013, and as the deficit falls the unemployment rate is expected to increase. The IMF research cited earlier suggests that reducing the government stimulus from an 11.2% deficit to 5.9% will increase unemployment by 1.6 percentage points.

The United Kingdom

While the U.K. is part of the European Union (EU), it is not a member of the EUR group. Rather, it has its own central bank and currency. And because of this, it can print money. As a member of the EU, its deficit and debt should not exceed 3 per cent and 60 per cent respectively for an extended period of time. The global recession has caused almost all EU members to exceed both limits.

The U.K. debt ratio is currently 71%. That puts it just above Spain but much lower than Greece. Its government deficit for the 2009/10 fiscal year was 11.4% of GDP. The new Conservative government recently announced an "austerity plan." Table 4 presents the austerity plan along with IMF estimates for unemployment in the coming years.

The Economist

wonders if the UK government can go through with its plan:

Even if loose monetary policy can ensure recovery in the teeth of fiscal consolidation, the Treasury's spending plans may simply not be feasible. With interest payments rising because of huge borrowing, and the NHS ring-fenced from real cuts, the departments responsible for other public services face cuts of 25% by 2014-15. If defence and schools are to be spared such harsh treatment--by limiting cuts to 10%, say--the others face a real squeeze of 33%. Cuts on this scale would be fiercer than any since the second world war.

Table 4 provides the IMF's projections for the U.K.

Looking at the figures in Table 4 might lead one to the conclusion that austerity will pay off: that as the budget deficit falls, consumers will become confident and spend more. But that is not the proper conclusion to draw. In September 2010, the unemployment rate was 7.8% and falling. Employment increased 286,000 this quarter. In short, the employment numbers are extremely promising. Promising enough to start reducing the size of the stimulus,

as I suggested in an earlier article.

Preliminary Conclusions

The EUR countries, Greece and Spain, have been forced into severe austerity programs. The IMF believes these programs will cause unemployment to increase. Unemployment in these countries is already extremely high. Austerity supporters argue these steps will instill confidence and more spending. I hope so. But I expect the outcome will be more strikes and governments not making prescribed targets.

In the case of the U.K., employment rates were on the rise even before the austerity program was launched; therefore, the recovery cannot be attributed to the austerity program. The U.S. case and overall conclusions will be presented in Part 2 of this two-part series.

Investment Implications

Austerity programs or stimulus -- keep your money out of countries in or recovering from recessions.

1

Larry Kotlikoff has made this argument in numerous economic journals. He claims people spend less when government deficits are increased because they know they will have to pay off government debt "down the road".

2

"Will It Hurt? Macroeconomic Effects of Fiscal Consolidation", Chapter 3 of the IMF's October 2010 "World Economic Outlook"

3

According to EU legislation, a government deficit above 3% of GDP is considered to be "excessive".

Elliott Morss is an economic consultant and an individual investor in developing countries. He has taught at the University of Michigan, Harvard University, Boston University, among other schools. Morss worked at the International Monetary Fund and helped establish Development Alternatives Inc. He has co-written six books and published more than four dozen articles in professional journals.