Tag Archives: economic crisis

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.

New Housing Starts, While Better, Are Still Depressed

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US housing starts, private single family homes, January 1980 to August 2012The US Census Bureau released this morning its regular monthly report on US housing starts.  News reports were positive, noting that housing starts are rising and are now well above where they were.  Starts on private single family homes in August grew by 27% over what they were a year ago to a pace of 535,000 (at a seasonally adjusted annual rate), while starts on all private housing units, including multi-family units such as apartments, grew by 29% over the year ago figure to a pace of 750,000.

Such growth rates are substantial.  But looking at the figures over a longer period than just a year shows that the increases, while welcome, are not as strong as they would appear.  The housing market remains depressed, with housing construction still far below what a more normal level might be, and even further below where it was during the 2002 to 2006 housing bubble.  The graph above puts the recent figures in the longer term context.

The graph shows how new private housing starts (monthly, but at seasonally adjusted annual rates) have moved since 1980.  Housing starts can be volatile, but they have never been so volatile (going back to 1980) as the recent boom and collapse.  The housing bubble started to build in early 2002, and new starts reached an annualized (and seasonally adjusted) peak of over 1.8 million new units in January 2006.  They then fell steadily, and the collapse in the housing market was the major underlying cause of the overall economic collapse in 2008, in the last year of the Bush Administration.  They reached a trough of 358,000 in January 2009, the month Obama was inaugurated, a fall of 80% from the peak.  Since then they have increased, to 535,000 last month, but remain far below what they had been.

A recovery to the previous bubble peak would be unwarranted (on a sustained basis), as it was the build-up of an excess supply of housing which led to the bubble collapsing.  But the American population continues to grow and needs housing, and it is clear that the current pace of construction is insufficient (based on historical patterns).  Prior to 2002, new housing starts was on an upward trend, but at a moderate pace.  But to keep things simple and conservative, one can take as a reasonable floor of where housing starts need to be as the average in 2001, when 1.27 million units were started.

Based on this conservative benchmark, the new housing starts of 535,000 single family homes in August 2012 would need to increase by a factor of  almost 2 1/2 to return to a more normal level.  While this is better than where it was last year in August (when it would have had to triple to reach the benchmark), it still has a long way to go.

But as has been noted previously in this blog (see the posts here and here), the shortfall in home construction since the collapse of the bubble indicates suggests a substantial potential, once housing begins to recover.  (Note that these earlier blog posts focused on new home sales, while the current post focuses on the broader concept of new home starts.  The starts figure includes starts of home units that would not only be sold, but also those which would eventually be rented, whether by original intention or because the new home could not be sold, plus homes which were built by or for a specific owner.)  The need for new homes remains, as the population continues to grow.  In the short-run, families double up, or adult children continue to live with their parents, as was discussed in the blog posts cited above.  But as soon as they are able, these people want to buy their own homes.

Based on a 1.27 million units per year norm, the graph above shows the excess of new homes (shaded in blue) between 2002 and late 2006, and then the deficiency (shaded in red) since then to now.  Based on this norm, the excess of housing started during the bubble totaled 1.3 million units over the full period.  This excess has now been more than worked off.  The cumulative shortfall (shaded in red) comes to 3.9 million units, or triple the previous excess.  Stated another way, there is now a shortfall of a net 2.6 million single family housing units.  There will be pressure to catch up on this once the economy, and the housing market, begins to recover.

Such a catch-up on the accumulated short-fall in new home construction of recent years could serve as a significant stimulus to the economy, as was discussed in the blog posts cited above.  Other commentators, such as Paul Krugman recently, have noted this as well.  But while such a stimulus to demand would be welcome, one needs also to recognize that fiscal drag has been quantitatively more important than the collapse in residential construction in explaining the lack of a strong recovery from the 2008 collapse.  This was discussed in a posting on this blog from last March.  Residential construction is only 2.4% of GDP currently, down from over 6% of GDP at the peak of the bubble, and about 4% of GDP in more normal times.  Government consumption and investment (as in the GDP accounts) is about 20% of GDP, and total government spending (including transfer payments, such as for Social Security or Medicare) is 36% of GDP.  Government is a much larger share of the economy than is residential construction.  Because of this, reversing the fiscal drag resulting from the scaling back of government expenditures in recent years (particularly at the state and local level) and allowing it to grow as it had during the Reagan years, would add more to the economy than a recovery in housing, welcome as a recovery in housing would be.  Numbers are provided in the March post cited above.

In summary, while there have been recent positive signs, housing construction remains depressed.  However, because housing construction has been so depressed for so long, there is now a shortfall in housing units relative to what is needed for a growing population.  Hence a recovery in new home construction should be expected as the economy begins to recover, and could lead to a doubling or tripling of new home construction from where it is now.  This would be a welcome stimulus to the economy.  But welcome as this would be, allowing government expenditures to recover would make an even larger contribution.

The US Personal Savings Rate: A Recent Fall, but Still Well Above the Rate of a Few Years Ago

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US personal savings rates, 1950 to 2012, US personal savings as a percentage of disposable personal income

In a posting yesterday on this blog on the initial GDP estimates for the first quarter of 2012, I noted that GDP growth had slowed further (to just 2.2%) from a rate that was already less than what it needs to be in a recovery.  The primary reason for this slow growth was the continued cuts (yes cuts, despite what Romney has been saying) in government expenditures, which reduced GDP growth by 0.6% points from what it otherwise would have been.  The cuts in government expenditures are now at the federal level in addition to cuts at the state and local level, and they act as a substantial drag on demand for production.  GDP growth also decelerated, although to a lesser extent, due to a fall in business fixed investment (which reduced GDP growth by 0.2% points for what it would otherwise have been).

The primary bright spot in the new numbers was the acceleration in growth of personal consumption expenditure, which grew at a 2.9% rate and accounted for 2.0% points of the GDP growth, and especially the growth of residential fixed investment (housing construction primarily), which grew at a 19.1% rate and added 0.4% points to growth.

Some observers of this data also noted that the figure for the personal savings rate declined in the quarter, as personal consumption rose at a faster rate than personal income.  This is correct, and there is therefore the concern whether personal consumption will be able to continue to grow at the rate it did in the first quarter.  Specifically, the personal savings rate was 4.5% in the fourth quarter of 2011, and this fell to 3.9% in the first quarter of 2012.  If personal consumption expenditure will end up being forced down as households seek to keep savings at some level, the primary support to recent growth of GDP will be lost.  Coupled with the political pressure from Republicans and other conservatives to keep cutting government expenditures further, and with weak business investment due to the still high excess capacity in the economy and weak demand for production, growth could slow further and perhaps drop down into negative territory and thus into a new recession.

The question then is whether the reduction in the savings rate to 3.9% from 4.5% in the previous quarter may lead to pressure on households to reverse this and start saving more, and hence end up cutting personal consumption.  This is indeed possible, and the consequence could then be slower growth if government remains constrained in what it is allowed to spend.  It is not really possible to predict with any confidence whether this will happen, but it is useful to put the reduction in savings to 3.9% this past quarter in a longer term context, to see where it now stands compared to what it has been in the past.

The diagram above does this, showing the personal savings rate in the national income accounts going back all the way to 1950.  The data comes from the GDP and Personal Income Accounts of the Bureau of Economic Analysis.  The lines in red show the trends, and are simply hand-drawn to make the trends easier to discern.  What is interesting is how the person savings rate trended upwards from 1950 to the early 1980s, rising from roughly 7 to 8%, to around 10 to 11% (although with a good deal of short-term variation around the trend rate in these quarterly numbers).  But then the trend shifted to a steady fall, bringing the personal savings rate to just 1 to 2% by around 2005.  Savings then jumped to around 5 to 6% at the time of the economic and financial collapse in 2008, and has then come down some, to the current 3.9%.  It is too soon to tell where the recent fluctuations since the trough in 2005 will lead, and what the new trend, if any, will be.

A careful analysis that might explain why the personal savings rate has varied in the way it has in the post-World War II period is beyond the scope of this note.  But a good hypothesis would be that the shift to a strong downward trend since the early 1980s is related to changes brought in by Reagan, and in particular due to the deregulation of the financial markets that started then.  As a consequence of regulatory and other changes of the period, it became easier for banks to provide home equity loans to households, with only a second lien on the homes backing these credit lines.  As a result, home equity loans exploded, from just $1 billion outstanding in 1982 to $100 billion in 1988 (these figures are from a New York Times article describing the early growth and the impact of advertising in encouraging this), to $215 billion in 1990, $408 billion in 2000, and $1.1 trillion in 2006.  The market then finally stabilized, started to fall in 2009, and by 2011 the outstanding was $873 billion (the figures since 1990 are from the US Fed; its series on home equity credit lines do not go back further than 1990).  There were also other regulatory and consequent institutional changes in the credit markets during this period, which made it easier for households to borrow.

As households found it possible to borrow against their home equity values, during a period when house prices rose and then soared, it was possible for households to spend on consumption beyond what their current income alone would allow.  Some households thus had negative savings, some had low savings, and averaged across all households, savings rates fell.  This is what one sees in the graph above.

This all ended with the 2008 collapse, and indeed the housing bubble was already starting to deflate earlier, as the housing peak was in 2006 (see my blog posting here).  Home prices collapsed, there was no home equity to borrow against, spending in excess of income could not be done, and the average savings rate then rose.  With the crisis now easing and with credit slowly becoming more available, it is not yet clear whether savings rates will fall back down to where they were in the decade prior to 2008, or whether they will remain roughly where they have been since 2008, or indeed whether they will rise back to where they were before Reagan.

Savings rates more like what they have been in recent years, and indeed higher than that and back to where they were prior the changes launched by Reagan, will be important for the long-term health of the US economy.  Investment needs to be higher, while the US international deficits (the trade and current account deficits) need to be smaller.  This can only happen with higher savings.  But higher savings in the near term, when the economy remains weak and with government constrained by Republican opposition in what it is allowed to spend, will lead to even slower GDP growth.  Finding the right path through this will be tricky.