Fiscally Prudent Germany: Government Expenditures Have Grown, Despite the Rhetoric

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Europe GDP Growth, 2007Q4 to 2012Q3 - 1

Germany & US - Govt Cons & Investment, 2007 to 2011

Germany & US - Govt Expenditures, Revenues, Deficit - 2007Q4 to 2012Q3

As was noted in the preceding post on this blog, austerity programs implemented in most of the major European economies in 2010/2011 have led to a double-dip recession in Europe, as the incipient recovery of 2009/2010 was killed.  Germany would appear to be an exception to this, as the German economy (like that of the US) continued to grow in 2011 and 2012.  The top graph above (repeated here from the preceding blog post) shows the growth since the end of 2007 for Germany, the US, and for the Eurozone area as a whole, as well as for France, the Netherlands, and the UK.

Germany, led by Angela Merkel of the conservative Christian Democrats since 2005, has been especially adamant in insisting on the austerity programs.  She pushed for such programs in much of the continent, and in particular as a condition of financial loan support from Germany in the cases of Spain, Italy, Greece, and others.  She was also the principal proponent of the “fiscal compact” under which EU member governments would be required to maintain balanced budgets.

Given all this, one would have expected that Germany itself would have followed a strict austerity program.  However, it in fact allowed government expenditures to rise relatively sharply (see the second graph above), and by a good deal more than in the US.  What is different in Germany is that it also kept up its government revenues, rather than seek to stimulate the economy through tax cuts.  This is seen in the third graph.  The result is that while German fiscal deficits grew, to almost 5% of GDP in 2010, they remained well below the deficits seen in the US and elsewhere.  The deficit was then reduced in 2011 as revenues rose and expenditure growth was moderated, but with a resulting slow-down in German growth in 2011 and 2012 (see the top graph).

In contrast to Germany, the US had government consumption and investment expenditures level off in 2010 and then fall in 2011 (second graph).  Total government expenditures (including transfer payments, such as for Social Security and Medicare) were reduced after peaking in the second quarter of 2009 (third graph).  But the US also cut back sharply on taxes (as discussed in this blog post).  The result was an increase in the overall government deficit to over 12% of GDP (for all levels of government).  This has now come down to about 8 1/2% of GDP, but remains high.

Germany is often cited as an example by conservatives in the US and elsewhere of prudent fiscal policy in response to the crisis.  The German fiscal deficit is indeed relatively modest.  But the German deficit is modest not because government expenditures are low, but because Germany has kept government revenues high.  Indeed, German government expenditures are a good deal higher than they are in the US as a share of GDP (21% higher in 2011).  But German government revenues are also far higher than they are in the US (64% higher in 2011, as a share of GDP).  The prudence comes not from low government expenditures, but from ensuring government revenues are kept high to pay for such expenditures.

Senator Mitch McConnell, the Republican Leader in the Senate, has said repeatedly in recent years:  “We’re not in this mess because Washington taxes too little; we’re in this mess because Washington spends too much.”  The example of conservative and fiscally prudent Germany points to the opposite:  We are in trouble not because Washington spends too much, but because it taxes too little.

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Notes on Data

The data for Germany comes from the European statistical agency Eurostat.  It is an excellent source of consistent data for all members of the European Union.  However, national accounts and fiscal data for Europe are gathered differently in the US, which sometimes makes it difficult to arrive at directly comparable data.  In particular:

  • Quarterly data on government total expenditures and revenues are not available on a seasonally adjusted basis.  Furthermore, the most recent quarterly data reported is only for the period through the fourth quarter of 2011.
  • While seasonally adjusted quarterly data (in real, inflation-adjusted, terms) are available in the national income (GDP) accounts for government consumption, the national income accounts in Europe do not show government investment separately.  Rather, government investment is combined with private investment in the European accounts.  In the US, the national income accounts record government consumption and government investment together.
  • Real government investment is available separately on an annual basis for the European economies, which is why the second graph above shows these numbers on an annual rather than quarterly basis.
  • Total government expenditure (for not just consumption and investment, but also including transfer payments such as for old-age pensions, medical care, unemployment insurance, etc.) is available on a quarterly basis, but only in nominal terms (i.e. not inflation adjusted) and not on a seasonally adjusted basis.  The German data in the third graph was therefore shown as a share of GDP, and the lack of seasonal adjustment accounts for the quarterly fluctuation seen.  When figures are quoted in the text (such as for 2011 government expenditures and revenues) the four quarter average was used.
  • The US data comes from the Bureau of Economic Analysis (BEA) of the US Department of Commerce.

Finally, note that “government” as defined here includes all levels of government:  federal, state, and local.

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?