Austerity versus Stimulus: The Right Question to Ask

The European Central Bank has announced its commitment to keeping interest rates low. This announcement comes following the criticism many European Union countries voiced against the European austerity measures and their failure to restore economic stability.

Europe adopted fiscal austerity as the path to recovery for its economy. The reason was that the debt-to-GDP ratios were too large in Europe, i.e. they were spending a lot more than their earnings, which is not sustainable. Therefore, in order to achieve lasting stability, budgets were to be balanced.  Also,  while stimulus would have made and kept Euro’s value low making its goods competitive, it would have also caused inflation which Germany feared.  Therefore, the European Union did not have many options but to adopt austerity. Europe set about raising taxes, where they were already back-breaking, but did not quite cut spending. 

On the other hand, despite a debt-to-GDP ratio of approximately 105 percent, the U.S. signed a huge stimulus bill and aggressively started pumping money into the economy (The stimulus of 2009-12 averaged over 6 percent of GDP annually – source: The Wall Street Journal). This unwavering commitment to an expansionary stance and aggressive quantitative easing policy even earned Ben Bernanke the nickname ‘Helicopter Ben’ for talking about using a ‘helicopter drop’ of money to fight a slowing economy.  However, just like EU did not go all the way with austerity, the U.S. also shied away from a full stimulus.  Deficit reduction efforts were taking place in parallel, although not as strongly as in Europe.

So, which has been a better response? Austerity measures have a contractionary effect on economies. Keynesian economists argue that during recessions, when the economy is already shrinking, stimulative polices such as increased government spending, tax cuts, lowering interest rates are a more appropriate response. The stimulus allowed the U.S. to experience faster growth than Europe, and keep unemployment levels well below Europe’s 12 percent (Youth unemployment is as high as 25 percent in Europe). Although the U.S.’s economy has fared better, both policy measures have had little success.

One argument I have come across, made by Charles Wolf Jr.,  is that the success of either policy depends on the response of the private sector. In both, the U.S. and Europe, the private sector did not respond positively to the policies and not much was done to mitigate the reasons for this response.  In the U.S., after 2009, private and household savings went up which offset the goal of the stimulus to increase aggregate demand. Private businesses were investing abroad instead of at home, which also did not help the stimulus.

Another argument is that neither policy was adopted fully and completely. Although on paper and in the media, Europe was on the path to austerity, government spending was actually rising (see chart below for government spending before and after the crisis). In the U.S. as well, many government spending programs were cut to control the deficit.  

 

(Source: Constantine Gourdiev’s research)

Latvia has been hailed as the poster child for adopting complete austerity – even though it is not a triumphant success. Being the hardest hit economy in EU in 2008/2009, during the two years that followed Latvia's government sacked 30 percent of public sector staff and cut salaries by 40 percent. New taxes were introduced and existing ones were raised. As a result, the economy registered positive growth as GDP grew by 5.5 percent and 4.5 percent in 2011 and 2012 respectively. This is all good, but only in relative terms. Latvia has not bounced back to pre-crisis growth levels, and unemployment is still quite high at 15 percent (source: cnbc.com).

In light of all this, a more poignant question to ask would be which sectors of the economy are being affected by stimulus and austerity measures. Both measures have merit, so long as intelligent cuts and spending decisions are made; i.e. cutting spending on over-sized and non-competitive sectors, such as defense and public administration, while increasing spending on education and infrastructure which can have a significant impact on recovery.