Category Archives: Fiscal Issues

An Update on the Impact of the Austerity Programs in Europe and a Higher Tax on Consumption in Japan: Still No Growth

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GDP Growth in Eurozone, Japan, and US, 2008Q1 to 2014Q3

A.  Introduction

With the release last Friday by Eurostat of the initial GDP growth estimates for most of Europe for the third quarter of 2014, and the release on Monday of the initial estimate for Japan, it is a good time to provide an update on how successful austerity strategies have been.

B.  Europe

As was discussed in earlier posts in this blog on Europe (here and here), Europe moved from expansionary fiscal policies in its initial response to the 2008 downturn, to austerity programs with fiscal cutbacks starting in 2010/11.  The initial expansionary policies did succeed in stopping the sharp downturn in output that followed the financial collapse of 2008/2009.  European economies began to grow again in mid-2009, and by late 2010 had recovered approximately two-thirds of the output that had been lost in the downturn.

But then a number of European leaders, and in particular the leaders of Germany (Chancellor Angela Merkel and others) plus the then-leader of the European Central Bank (Jean-Claude Trichet), called for fiscal cuts.  They expressed alarm over the fiscal deficits that had developed in the downturn, and argued that financial instability would result if they were not quickly addressed.  And they asserted that austerity policies would not be contractionary under those circumstances but rather expansionary.  Trichet, for example, said in a June 2010 interview with La Repubblica (the largest circulation newspaper in Italy):

Trichet:  … As regards the economy, the idea that austerity measures could trigger stagnation is incorrect.

La Republicca:  Incorrect?

Trichet:  Yes. In fact, in these circumstances, everything that helps to increase the confidence of households, firms and investors in the sustainability of public finances is good for the consolidation of growth and job creation.  I firmly believe that in the current circumstances confidence-inspiring policies will foster and not hamper economic recovery, because confidence is the key factor today.

So what has actually happened since the austerity programs were imposed in Europe?  The chart at the top of this post shows the path of real GDP for the larger Eurozone economies as well as for the Eurozone as a whole, plus Japan and the US for comparison.  The data for Europe (as well as the US) comes from Eurostat, with figures for 2014Q3 from the November 14 Eurostat press release, while the data for Japan came most conveniently from the OECD.  Real GDP is shown relative to where it was in the first quarter of 2008, which was the peak for most of Europe before the 2008/09 collapse.

In a word, the results in Europe have been terrible.  Real GDP in the Eurozone as a whole is basically the same as (in fact slightly less than) what it was in early 2011, three and a half years ago.  To be more precise, real GDP in the Eurozone fell by a bit more than 1% between early 2011 and early 2013, and since then rose by a bit over 1%, but it has basically been dead.  There has been no growth in the three and a half years since austerity programs took over.  And Eurozone output is still more than 2% below where it had been in early 2008, six and a half years ago.

Since early 2011, in contrast, the US economy grew by 8.6% in real terms.  Annualized, this comes to 2.4% a year.  While not great (fiscal drag has been a problem in the US as well), and not sufficient for a recovery from a downturn, the US result was at least far better than the zero growth in the Eurozone.

There was, not surprisingly, a good deal of variation across the European economies.  The chart shows the growth results for several of the larger economies in the Eurozone.  Germany has done best, but its growth flattened out as well since early 2011.  As was discussed in an earlier post, Germany (despite its rhetoric) in fact followed fairly expansionary fiscal policies in 2009, with further increases in 2010 and 2011 (when others, including the US, started to cut back).  And as the chart above shows, the recovery in Germany was fairly solid in 2009 and 2010, with this continuing into 2011.  But it then slowed.  Growth since early 2011 has averaged only 0.9% a year.

Other countries have done worse.  There has been very little growth in France since early 2011, and declines in the Netherlands, Spain, and Italy.  Spain was forced (as a condition of European aid) to implement a very tight austerity program following the collapse of its banking system in 2008/09 as a consequence of its own housing bubble, but has loosened this in the last year.  Only in France is real GDP higher now than where it was in early 2008, and only by 1.4% total over those six and a half years.  But France has also seen almost no growth (just 0.4% a year) since early 2011.

C.  Japan

The new figures for Japan were also bad, and many would say horrible.  After falling at a 7.3% annualized rate in the second quarter of this year, real GDP is estimated to have fallen by a further 1.6% rate in the third quarter.  The primary cause for these falls was the decision to go ahead with a planned increase in the consumption tax rate on April 1 (the start of the second quarter) from the previous 5% to a new 8% rate, an increase of 60%.

The Japanese consumption tax is often referred to in the US as a sales tax, but it is actually more like a value added tax (such as is common in Europe).  It is a tax on sales of goods and services to final consumers such as households, with offsets being provided for such taxes paid at earlier stages in production (which makes it more like a value-added tax).  As a tax on consumption, it is the worst possible tax Japan could have chosen to increase at this time, when the economy remains weak.  There is insufficient demand, and this is a straight tax on consumption demand.  It is also regressive, as poor and middle class households will pay a higher share of their incomes on such a tax, than will a richer household.  With its still weak economy, Japan should not now be increasing any such taxes, and increasing the tax on consumption is the worst one they could have chosen.

With recessions conventionally defined as declines in real GDP in two consecutive quarters, Japan is now suffering its fourth recessionary contraction (a “quadruple-dip” recession) since 2008.  This may be unprecedented.  Japan’s output is still a bit better, relative to early 2008, than it is for the Eurozone as a whole, but it has been much more volatile.

Prime Minister Shinzo Abe was elected in December 2012 and almost immediately announced a bold program to end deflation and get the economy growing again.  It was quickly dubbed “Abenomics”, and was built on three pillars (or “arrows” as Abe described it).  The first was a much more aggressive monetary policy by the Central Bank, with use of “quantitative easing” (such as the US had followed) where central bank funds are used to purchase long term bonds, and hence increase liquidity in the market.  The second arrow was further short-term fiscal stimulus.  And the third arrow was structural reforms.

In practice, however, the impacts have been mixed.  Expansionary monetary policy has been perhaps most seriously implemented, and it has succeeded in devaluing the exchange rate from what had been extremely appreciated levels.  This helped exporters, and the stock market also boomed for a period.  The Nikkei stock market average is now almost double where it was in early November 2012 (when it was already clear to most that Abe would win in a landslide, which he then did).  But the impact of such monetary policy on output can only be limited when interest rates are already close to zero, as they have been in Japan for some time.

The second “arrow” of fiscal stimulus centered on a package of measures announced and then approved by the Japanese Diet in January 2013.  But when looked at more closely, it was more limited than the headline figures suggest.  In gross terms, the headline expenditure figure amounted to a bit less than 2% of one year’s GDP, but the spending would be spread over more than one year.  It also included expenditures which were already planned.  It therefore needs to be looked at in the context of overall fiscal measures, including the then planned and ultimately implemented decision to raise the consumption tax rate on April 1, 2014.  The IMF, in its October 2013 World Economic Outlook, estimated that the net impact of all the fiscal measures (including not only the announced stimulus programs, but also the tax hike and all other fiscal measures) would be a neutral fiscal stance in 2013 (neither tightening nor loosening) and a tightening in the fiscal stance of 2.5% of GDP in 2014.  The fall in GDP this year should therefore not be a surprise.

Finally, very little has been done on Abe’s third “arrow” of structural reforms.

On balance, Abe’s program supported reasonably good growth of 2.4% for real GDP in 2013 (see the chart above).  There was then a spike up in the first quarter of 2014.  However, this was largely due to consumers pulling forward into the first quarter significant purchases (such as of cars) from the second quarter, due to the planned April 1 consumption tax hike.  Some fall in the second quarter was then not seen as a surprise, but the fall turned out to be a good deal sharper than anticipated.  And the further fall in the third quarter was a shock.

As a result of these developments, Abe has announced that he will dissolve the Diet, hold new elections in mid-December with the aim of renewing his mandate (he is expected to win easily, due to disorder in the opposition), and will postpone the planned next increase in the consumption tax (from its current 8% to a 10% rate) from the scheduled October 2015 date to April 2017.  Whether the economy will be strong enough to take this further increase in a tax on consumption by that date remains to be seen.  The government has no announced plans to reverse the increase of 5% to 8% last April.

Japan’s public debt is high, at 243% of GDP in gross terms as of the end of 2013.  Net debt is a good deal lower at 134% (debt figures from IMF WEO, October 2014), but still high.  The comparable net debt figure for the US was 80% at the end of 2013 (using the IMF definitions for comparability; note this covers all levels of government, not just federal).  Japan will eventually need to raise taxes.  But when it does, with an economy just then emerging from a recession due to inadequate demand, one should not raise a tax on consumption.  A hike in income tax rates, particularly on those of higher income, would be far less of a drag on the economy.

Already Low Public Investment Has Fallen Sharply Under Obama

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Public Investment Share of GDP, 1952-2013

 

A.  Public Investment as a Share of GDP

Public investment has fallen sharply under Obama, from already low levels.  This may come as a surprise to many, given the repeated assertions of conservatives that government has grown radically during his presidential term.  Obama has indeed repeatedly called for the need to revive public investment, particularly at a time when unemployment has been high, and government borrowing rates have been essentially zero in real terms.  But Republican control in Congress has blocked this.

Net public investment after depreciation (and excluding public investment by the military) has as a result fallen in half during Obama’s tenure in office, from an already low 1.2% of GDP in 2009, to just 0.6% of GDP in 2013.  And contrary to a common belief, net public investment in 2009 was not exceptionally high.  To be precise, it came to 1.20% of GDP in 2009, and an almost identical 1.19% of GDP in 2007 and again in 2008.  The 2009 stimulus program, with its focus on tax cuts, did not really do that much for public investment.  It rose, but only by barely more than depreciation rose that year on old investments.

The fall since 2009 would have been even greater had one included investment by the military, which has also been scaled back.  But the focus in this post will be on investment in our economy.

The figures are shown in the chart above.  The data are calculated from the numbers in the National Income and Product Accounts (NIPA accounts, often also referred to as the GDP accounts) from the Bureau of Economic Analysis.  The public investment figures shown here cover all forms of public investment by government other than by the military, and at all levels (federal, state, and local).  Using figures for 2013, 60% of the gross public investment was for public infrastructure, 27% was for research and development (as well as investment in software), and 13% was for equipment (such as computers).

Many observers focus solely on the gross investment figures, as these can be most easily measured.  The GDP shares for gross public investment are shown as the green line in the chart above.   But what matters for economic growth is the net addition to productive capacity from this investment, after one subtracts depreciation.  Investments wear out over time.  The BEA NIPA accounts include estimates of what this depreciation will be (worked out at the detailed individual product levels), and those estimates are shown as the blue line in the chart.  The difference between gross investment and depreciation is net investment, shown in red on the chart.

The net investment of 0.6% of GDP in 2013 is the lowest level of net (non-military) public investment as a share of GDP in 66 years, or two-thirds of a century.  In data going back to 1929 (the earliest year with official GDP estimates), it was only lower during World War II and the immediate post-war years (1942 to 1947), when non-military spending of all kinds was drastically scaled back.

Net public investment rose sharply as a share of GDP in the 1950s and up to the mid-1960s.  Its share of GDP doubled, from 1.5% in 1952 and again in 1953, to 3.0% at its peak in 1966.  This was the period when we invested in the then new Interstate Highway system, in new and expanded water and sewerage systems, and in government research and development (such as the Apollo moon mission).  The economy then grew strongly, with supportive infrastructure.  But public investment then started to be cut back sharply, reaching a trough in 1983 of just 0.9% of GDP, after which it fluctuated around a low level of generally 1.1 to 1.4% of GDP.  It then was cut back sharply again, by half, during the period Obama has been president.  Aside from 1942 to 1947, it is now at a historic low.

B.  Public Investment in Real Per Capita Dollar Terms

Another way to look at such figures is in real per capita terms.  Using prices of 2013, net non-defense public investment came to $291 per person in 1952.  It was only slightly more, at $313 per person, in 2013, an increase of just 8% in 61 years:

Real per Capita Dollar Terms Change Change
     2013 prices 1952 1968 2013 1952-2013 1968-2013
Non-Defense Net Public Investment $291 $783 $313 8% -60%
Per Capita Real GDP $16,675 $24,240 $52,985 218% 119%

Over this same period, real per capita GDP more than tripled, from $16,675 in 1952 to $52,985 in 2013.  It is ridiculous to say the US cannot now afford to invest more in infrastructure and other public assets.  We could afford to invest a similar amount to what we are investing now, when incomes were only one-third as high as now.

Per capita net pubic investment reached a peak in dollar terms in 1968, at $783 (in terms of 2013 prices).  (The peak as a share of GDP was in 1966, but GDP was growing strongly in those years, so the peak in dollar terms could come two years later.)  From that peak, per capita net public investment fell to the $313 of 2013, a fall of 60%.  But over that same period, real per capita GDP more than doubled.  We could certainly have afforded to have kept up, and indeed expanded, our investment in public infrastructure.  But the political choice was made not to.  The result has been our deteriorating public assets.

C.  Conclusion

The poor and inadequate condition of American infrastructure and other public assets should not be a surprise when one looks at how little we spend on such capital.  Net spending of just $313 per person in 2013 is tiny.  Doubling or tripling this would not be a big burden.

One can live on old capital, such as the roads and bridges we built in the 1950s and 60s, for a period of time, but eventually they do wear out.  Net public investment of just 0.6% of GDP will not suffice to support an economy that should be growing at 3 to 4% a year.  But what we have instead is an embarrassment at best (as anyone who has traveled abroad to Europe or East Asia knows), and one which will increasingly act as a drag on the economy.

The Government Debt to GDP Ratio is Falling

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Fed Govt Debt as Share of GDP, 2006Q1 to 2014Q3

The US federal government debt to GDP ratio is falling.  A few years ago, conservative critics (such as Congressman Paul Ryan) argued that if drastic action were not taken immediately to slash government expenditures, consequent rapidly rising federal government debt would stifle growth and spiral ever upwards.  Liberals (such as Paul Krugman) argued that the federal deficit and debt were far less of a concern than these critics asserted:  With the recovery of the economy, both would soon start to fall.  And the detailed projections from the Congressional Budget Office backed this up, with projected falls in the debt to GDP ratio for at least a few years.  There would be a rise later if nothing further is done, in particular on medical costs, but the question at issue here is whether the debt to GDP ratio could fall in the near term without drastic cuts in government expenditures.  Conservatives asserted it would not be possible.

But these were projections and assertions.  The chart above shows the actual data.  With the release this morning by the Bureau of Economic Analysis of its first estimate of 2014 third quarter GDP (growth at a fairly solid 3.5% real rate), one can now see that there has been a downward turn in the debt to GDP ratio.  The ratio peaked at 72.8% of GDP in the first quarter of 2014, and dropped to 72.2% as of the third quarter.

The federal government debt figure used here is the debt held by the public.  There are also various trust funds (most notably the Social Security Trust Fund) that formally hold government debt in trust, but this reflects internal accounting within government.  The figures come from the US Treasury, with quarterly averages taken based on an average of the amounts outstanding each day of the quarter.  This average is then taken as a share of nominal GDP for the quarter (nominal GDP since debt is also a nominal concept).  And since nominal GDP reflects the flow of production over the course of the quarter, taking the daily average debt outstanding over the course of the quarter will better reflect the debt burden than simply taking debt as of the end of the quarter and dividing this by GDP (although this is commonly done by many).

There was an earlier downward dip in the public debt to GDP ratio in the third quarter of 2013, but this was due to special circumstances surrounding the delay by Congress to approve a rise in the statutory government debt ceiling.  Various accounting tricks were used to delay recognition of items that would add to the formally defined government debt in order to keep under the ceiling, which artificially suppressed the debt to GDP ratio in that quarter.  This carried over into the fourth quarter, with the Republicans forcing a shutdown of the federal government from October 1 by not approving a new budget.  The dispute was not resolved until October 16, when deals were reached to raise the debt ceiling and to approve a budget.  The debt ratio then returned to its previous path.

The fall in the debt ratio in 2014 is more significant.  Accounting tricks are not now being used due to debt ceiling disputes, and the fall reflects the continued fall in the fiscal deficit coupled with reasonably sound growth.  The deficit is estimated to have totaled $483 billion in fiscal 2014 (which just ended on September 30), or 2.8% of GDP.  This is sharply down from the $1.4 trillion (or 9.8% of GDP) of fiscal 2009, in the first year of the downturn.  The fiscal deficit has fallen primarily due to the recovery, but also due to cuts in federal government expenditures under Obama since 2010.  While not nearly as drastic as Congressman Ryan and other conservatives had insisted would be necessary, government spending has still fallen under Obama, in contrast to the increases allowed in previous downturns.

Note that the government expenditure cuts that were done do not represent what would have been the desirable path in deficit reduction:  As discussed in an earlier post on this blog, it would have been far better to follow a fiscal path similar to that followed by Reagan and others in earlier downturns, with government spending allowed to grow so that the economy could have more quickly returned to full employment.  Once full employment was reached, one would then consider fiscal cuts, if warranted, to address any debt concerns.

The path followed has thus been far from optimal.  But it has shown that the alarms raised by the conservative critics, that the debt to GDP ratio could not fall without drastic government cutbacks (far more severe than that seen under Obama), were simply wrong.