The Example of Europe: Austerity Programs Are Indeed Contractionary

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Europe GDP Growth, 2007Q4 to 2012Q3 - 1A.  Introduction

As the US comes closer to the so-called “fiscal cliff” (actually, more of a “fiscal slope”, as many have noted, as the impact will build over time rather than hit abruptly), it is worth reviewing the experience of Europe with the type of austerity programs that many are now pushing for the US.  The fiscal cliff we are now facing in the US is a manufactured crisis, created at the insistence of Republicans in August 2011 when they finally approved a higher statutory federal government debt limit.  It is a set of measures that will automatically enter into force on January 1, 2013, unless an agreement had been reached before then on actions to drastically cut back the federal deficit.

Unfortunately the debate underway in Washington is not on whether it is wise now (with the still weak economy) to enter into an austerity program of some sort.  Rather, it is solely on how severe that austerity program should be.  Any agreement will lead to a reduction in government spending and to increases in taxes, relative to what they would have been without the measures being negotiated.

The Republican argument is that adoption of such an austerity program is necessary for the US to be able to continue to grow.  Similar arguments were made in Europe.  Much of the continent has now adopted austerity programs, either willingly (such as in the UK) or due to pressure from other EU members and in particular pressure from the German government (such as in the cases of Greece, Spain, and Italy).  Our aim here is not to review in each case the reasons why the different countries may have chosen to adopt these austerity programs, which as noted was sometimes by policy choice and sometimes as a result of outside pressure.  Rather, the aim is to see what the impacts on growth have been since the programs were adopted (for whatever reason).

It is worth recalling what was said when these programs were first being pushed by prominent European authorities.  While critics forecast that such austerity programs would kill the incipient recoveries from the 2008/09 collapse (that started in the US and then spread globally), the European authorities in favor of these austerity programs argued that there was no need to worry.  They argued that such austerity programs would in fact be expansionary rather than contractionary.

The most prominent example is perhaps in the arguments made by the then President of the European Central Bank, Jean-Claude Trichet.  For example, in a June 2010 interview with La Repubblica (the largest circulation newspaper in Italy), Trichet said:

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.

Trichet did not mis-speak.  He made a similar statement a month later in an interview with the newspaper Libération of France:

Libération:  Do the austerity plans announced amid monumental disarray by the Member States pose the risk of killing off the first green shoots of growth?

Trichet:  It is an error to think that fiscal austerity is a threat to growth and job creation. … Economies embarking on austerity policies that lend credibility to their fiscal policy strengthen confidence, growth and job creation.

But that has not been the case.

B.  The Larger European Economies, and Europe as a Whole

The figure above shows the paths of real GDP for the US, for several of the larger European economies, and for the Eurozone area as a whole, relative to the fourth quarter of 2007 (the peak before the start of the downturn in the US, and just before the start of the downturn in Europe, which for most was in the first quarter of 2008).  Some points to note:

  • The early path of the downturns were similar between the US and Europe, with a collapse in 2008 and into the first half of 2009, and then a start of a recovery with the stimulus packages adopted in the US as well as in much of Europe in 2009.
  • But then growth faltered in several of the European economies:  in mid-2010 in the UK, in early 2011 in the Netherlands, and more broadly in the 17 countries making up the Eurozone (who use the euro as their currency) in mid-2011.
  • The turnaround in the UK is particularly interesting for the US, as the UK (like the US) has its own currency and central bank, and can follow its own fiscal policy.  The abrupt end to the UK recovery in mid-2010 followed directly from new measures enacted by the then newly elected Conservative-led government (elected in May 2010, with initial emergency measures implemented from June, and a broader program implemented from October).  This was discussed in a previous blog post on this site.  Many of the Conservative government measures are similar to those being pushed by the Republicans in the US, with a sharp-cut back in government expenditures and in particular cuts in expenditures that provide support to the poor, accompanied by cuts in corporate taxes and more recently cuts in the top tax rates on the rich.
  • But while the Conservative Party argument for the UK austerity program was that this would lead to growth and to a reduction in government debt ratios, it is widely acknowledged now that the downturn that resulted from the austerity measures instead means that the program failed in terms of its originally stated objectives.  The austerity measures did not lead to an acceleration of growth, but rather to stagnation.  (And note that while there was an uptick in GDP by one percentage point in the third quarter of 2012, this has been attributed to the stimulus in spending resulting from the staging of the 2012 Olympics in London.  Indeed, the Bank of England in November, in its official forecast for the economy, noted GDP could fall back again in the fourth quarter of 2012 and downgraded its expected growth in 2013 to only 1%.)
  • Germany appears to be an exception, with a path followed for GDP above that of the US, although with a narrowing since mid-2011.  But while Germany has argued most strenuously and forcefully on the need for other European countries to follow austerity policies, its own internal government spending policies have been expansionary.  This is surprising given its rhetoric, and will be reviewed in a separate post on this blog which will be prepared after this one.  And it is also important to note that even with this performance, German GDP was only 2% higher in the third quarter of 2012 than it was in the first quarter of 2008, for a compound growth rate of only 0.4% per annum over four and a half years.
  • Each country has its own story, and it is not possible to review them all here.  But it is clear that for the Eurozone area as a whole, as well as for the UK but with the exception of Germany (which kept to expansionary government spending), the austerity programs launched in 2010 and 2011 have led to stagnation at best and falling output for most.

C.  Southern Europe and Ireland

There are two other groups of European economies where the response to austerity programs is of interest.  The first is the group of mostly Southern European economies were strict austerity policies were imposed as conditions of support programs from the IMF and the rest of Europe.  Funds were lent in these programs to those governments to enable them to continue to repay their creditors (who were in large part banks from Northern Europe).  This is the group affectionately known as the PIIGS, for Portugal, Italy, Ireland, Greece, and Spain.

The austerity measures led to collapses in output.  (A seasonally adjusted series is not available for Greece, but its path is clear.):

Europe GDP Growth, 2007Q4 to 2012Q3 - 2

D.  The Baltics

The other group of interest is the three small Baltic countries:  Estonia, Latvia, and Lithuania.  They were each severely impacted by the 2008/09 financial collapse, and each responded with stern austerity programs.  With strong growth over the last three years in each of them, these countries are sometimes held as examples of how austerity programs can lead to growth.  But this ignores the depth of the downturns that resulted from their austerity measures.  From the fourth quarter of 2007 to their troughs in 2009, GDP fell by 15% in Lithuania, by almost 20% in Estonia, and by an astounding 25% in Latvia.  There has been growth since then, but their current output remains far below where it was in 2007:

Europe GDP Growth, 2007Q4 to 2012Q3 - 3

Some have argued that the countries had no choice.  Estonia is a member of the Eurozone, and could not as a result depreciate an independent currency without leaving the Eurozone.  As in the other Eurozone members, monetary policy for Estonia is determined centrally by the European Central Bank, and fiscal policy is constrained by the extent to which the country will be able to borrow in the financial markets to finance any deficits.  But as noted above, the aim here is not to ascertain whether or not the countries had any policy choice on whether to follow some austerity program (or how severe that austerity program should have been), but rather what the impacts on growth have been of the austerity programs followed.  And the impacts have been negative.

Lithuania and Latvia had more scope in terms of policies they could have followed, since their currencies, while tied (by government decision) to some rate vis-a-vis the euro, are still independent currencies.  The governments could have chosen to devalue these currencies, which would have spurred their exports.  However, they decided not to, and instead decided to follow programs of severe fiscal austerity.  Output collapsed.

E.  Unemployment

The fall in output resulting from the austerity measures is bad enough by itself.  The loss in output is a loss in real resources, which could have been used for productive purposes.  But the tragedy is in fact much worse, as the pain from falling output is not spread evenly over the population, but rather is concentrated among a few.  In particular, those who lose their jobs and become unemployed see a drop not only in their current living standards, but for many also a permanent loss in their real standard of living, and for all a psychological burden as well.

It is therefore tragic to see how unemployment rates have risen, to almost 12% for the Eurozone as a whole, and to 26% in Spain and Greece following their particularly severe austerity programs:

European Unemployment Rates, Dec 2007 to Oct 2012F.  Conclusion

The austerity programs implemented in Europe killed the recoveries which were underway in 2009/2010, and led to double-dip recessions.  Unemployment had started to decline in the Eurozone area as a whole, but then rose following the new austerity programs, reaching a rate of almost 12% recently.  The US economy has so far fared better, with positive growth and a decline in the unemployment rate from a peak of 10.0% to a rate of 7.7% in November 2012.

But there is now the strong danger that if the negotiations under the threat of the fiscal cliff leads to new austerity measures, with expenditure cuts and tax increases starting in 2013 in order to reduce rapidly the federal fiscal deficit, that the consequences in the US will be similar to that which has been seen in Europe.

Romney’s Proposal to Cut to Zero the Taxes on Income from Wealth for those Making Up to $200,000

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Having just watched the second presidential debate between President Obama and former Governor Romney, I want to make a quick point on Romney’s tax proposals that have not been much commented upon.

It is well known that Romney has proposed a tax plan where he would cut all individual income tax rates by 20%.  It is accepted by all, including Romney, that this by itself would cut tax revenues by about $5 trillion over ten years, but that Romney then says he would also cut certain (but unspecified) tax deductions and other preferences in the tax code so as to raise back that $5 trillion and thus make the overall plan revenue neutral.

While this has been much discussed (and the impossibility of doing this without increasing taxes on the middle classes has been noted by neutral observers, including the Tax Policy Center, a group that Romney himself had praised during the Republican primaries), certain other aspects of his tax proposals have been less discussed.  One, which Romney highlighted in the debate tonight, would be that he would cut to zero the income earned from dividends, interest, and long term capital gains, for all households earning up to $200,000 a year.

Note what this implies.  Suppose you are someone who has $4 million in wealth.  Perhaps you inherited this from someone, or struck it rich in the stock market, or won the lottery.  And suppose you are earning a modest 5% on this $4 million from dividends plus interest plus long term capital gains.  You would then be receiving $200,000 a year from this wealth.  While perhaps not really rich, the income is good enough for you, so you do not work.  Under Romney’s proposal, you would pay zero in federal taxes.

In contrast, suppose you work for a living, earning $100,000 a year (or half of what the better off individual described above earns simply from his wealth).  You would pay Social Security and Medicare taxes at a rate of 15.3% on this (total, including the half that is nominally is “paid by” the employer, which all analysts, including Republican ones, agree comes out of worker wages).  You would also be in the middle of the 25% tax bracket currently for federal income taxes, which would fall to 20% under Romney’s proposal to cut all rates by 20%.

Even ignoring the additional taxes you would pay under Romney’s proposal to reduce or eliminate certain (but unspecified) tax deductions and tax preferences, the individual earning $100,000 a year would pay taxes at a marginal rate of 35.3% ( = 15.3% + 20%).  But the wealthy individual, with $4 million in wealth making $200,000 a year would pay absolutely zero.

How can this be considered fair?

The Recovery of Private Jobs Under Obama, versus the Fall Under Bush. And the Cuts in Government Jobs Under Obama, versus the Rise Under Bush.

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Cumulative growth of private jobs, from January 2009 to September 2012 for Obama, and from January 2001 to September 2004 for Bush

Cumulative growth of government jobs, from January 2009 to September 2012 for Obama, and from January 2001 to September 2004 for Bush

 

[Update on February 2, 2013:  A more recent analysis of these issues, with these charts now covering the full first term of Obama, is available here.]

Private jobs have grown under President Obama while they fell during the similar period of the administration of President Bush.  And government jobs have fallen during Obama’s term while they rose under Bush.  The figures above, prepared from data from the Bureau of Labor Statistics, shows the cumulative change in the number of private and government jobs, respectively, from their inaugurations to September of the fourth year of their administrations.  This updates similar graphs and analysis posted earlier on this blog (here and here), although with a focus now on only Obama and Bush.

Obama has been heavily criticized by Republican nominee Mitt Romney and by Republicans more generally for doing a terrible job on jobs.  Their repeated theme is that the US has to return to the policies of George W. Bush of tax cuts, deregulation, and small government in order to create a “business friendly” environment in which private businessmen will then create jobs.

But as the top graph shows, private jobs have grown under Obama, in contrast to a fall under Bush.  Obama was faced with a collapsing economy when he took office, with private jobs falling by 800,000 a month as he was taking office.  He was able to turn this around within only a few months, as the stimulus package and other measures entered into effect, and jobs growth turned positive after just one year in office.  This was a strong turnaround from the sharpest downturn the US economy had faced since the Great Depression.

Since then, private job growth has continued each and every month, but at an overall pace that has been criticized.  But the pace of recovery has in fact been better than that observed under Bush, where the number of private jobs had fallen steadily for the first two and a half years into his term (and with the fall starting only after he took office, in the Spring of 2001).

Based on the current official numbers, there were about 0.5 million more private jobs in September 2012 than when Obama took office.  This already contradicts the Republican claim that Obama’s policies have been destroying jobs.  And the growth in private jobs has in fact been even higher.  The BLS recently announced their preliminary estimate that in their regular annual re-benchmarking process, the number of private jobs were 453,000 higher in March 2012 than previously estimated.  This would be an increase of 0.4% over the previous BLS estimate for private employment, and such a change is about average.  Over the eleven years of 2002 to 2012, the changes due to the annual benchmark re-estimates have ranged between 0.1% and 0.9% (in absolute terms) – sometimes positive and sometimes negative.  The BLS has not yet revised their job estimates reflecting this new benchmark; this will be done in early February 2013, when the revisions will be announced along with the January 2013 job figures.

Based on the pattern observed in the previous annual re-benchmarking exercises, the March figure is likely to change by about the amount of the benchmark change (it will not be exactly the same for a number of reasons), with changes before that reaching back into 2011 diminishing as one goes back to the previous March 2011 benchmark period, and the changes increasing as one goes forward in 2012 from the March 2012 benchmark.

Until the new analysis is done by the BLS experts and the standard models run, there is no way to say what the changes will be.  For the diagrams above, I have very simplistically simply raised each of the 2012 private job estimates by 453,000, to give one a visual sense of the magnitude of the change.  In reality, the increase will be phased in rather than jump abruptly as depicted, but it is not yet known how it will be phased in so I have not tried to show this.

Based on this simple assumption, private jobs during Obama’s term from his inauguration to September 2012 have increased by about 1.0 million.  During the similar period under Bush, private jobs fell by 1.5 million.  Yet Obama is criticized for his job growth record, while Bush is praised.

Furthermore, since the turnaround in jobs that Obama was able to achieve after just one year in office, private jobs have increased by 4.7 million based on the current official estimates, or by 5.2 million with the adjustment made for the new benchmark

While private jobs have grown under Obama (in contrast to the fall under Bush), government jobs have fallen under Obama (and grew under Bush).  Again, this contradicts the repeated Republican charge that Obama has presided over an explosion of government jobs and government spending, which is simply not true.  (Note that the temporary blip seen in the 16th month after Obama’s inauguration is the temporary hiring for the 2010 census.  After a few months, government jobs returned to their previous path of decline.)

As seen in the figure above, government jobs have fallen by 575,000 during Obama’s term up through September 2012, using the current official BLS estimates.  But the BLS benchmark revision, discussed above, estimates that there were 67,000 fewer government jobs in March 2012 than previously estimated.  Adding this as a simple adjustment, government jobs fell by 642,000 during Obama’s term in office so far.  Keep in mind that these are primarily state and local government jobs, as they account for 87% of government jobs in the US.  But federal jobs have been flat over this period with no sharp increase either, and fell if one excludes an increase in the number of Defense Department employees.

And in contrast to the fall in government jobs during Obama’s tenure, government jobs rose during the similar Bush period.  Between his inauguration in January 2001 and September 2004, government jobs rose by 800,000 under Bush.  There would be over 1.4 million additional jobs (mostly of school teachers, police, and other state and local workers) due to the direct impact alone if government jobs had been allowed to grow as they had under Bush rather than fall as they have under Obama.  With a multiplier of two, there would be 2.8 million more jobs, and unemployment would be 6.0% instead of 7.8%.  Unemployment would then be at the top end of what is generally considered to be the full employment range of unemployment (which will never be zero, due to turnover and other frictions).

The myth is therefore quite different from the reality.  Government jobs have been cut back during Obama’s term, and this has acted as a considerable drag on the economy.  If government jobs had been allowed to increase during Obama’s term by as much as they had under Bush, we would now be at, or close to, full employment  (see some further estimates at this blog posting).  Yet Republicans continue to call for further and drastic cut-backs in government, with no recognition that there have already been sharp cuts and that these cuts have held back the pace of recovery.