Monday, May 7, 2012

Austerity versus Stimulus: A prominent but useless and even harmful argument.

            I often voiced my opinion that we do not have an accurate view of the post 2007 world and the causes, then and now, which are at the root of the current economic symptoms.  We in fact are guilty of mistaking the symptoms as the actual cause of the ailment.  In my previous article I pointed out the effect that a 150% rise in the global food price and the 500% rise in oil prices since 2000, had on crowding out the non-commodity economy.  I also pointed out that the financial and monetary carelessness we witnessed in the past decade is in fact the automatic response of market and political forces to the pressures on the economy from the above mentioned commodity related difficulties. 

            Now we still have near record high commodity prices, with a few exceptions, such as natural gas.  We also have the aftermath of the mess that the market and political establishment created in its wrongheaded response to the sustained pressure on the economy, caused by the above mentioned rise in commodity prices, which many do not realize but is unprecedented on a global scale. 

            In the face of the absurdly large deficits that, countries such as the US are running, and continuing financial instability in Europe, the political establishment is now pushing for austerity measures to re-stabilize the western world.  There is also a counter voice, which argues for Keynesian stimulus.  In Greece and Eastern Europe, austerity is already a years old practice.  As a result, Eastern Europe, which has all the ingredients necessary to grow at a similar pace as their developing nation Asian counterparts, is stuck in a stagnated mode.  Greece has been in recession for almost half a decade now.  Austerity in Western Europe is in large part responsible for the double dip recession the Euro zone and Britain are experiencing.  In the US, if the tax hikes and spending cuts will go in effect by the end of this year, or at the beginning of next year, as they are scheduled to do in the absence of legislative intervention, they will also enter a recession.  The tax hikes and the spending cuts amount to about 5% of GDP, while the US economy is only growing at 2%, which means the contraction could be deep.

Will Austerity solve the problem?

            I think by far the best barometer of the effects of austerity is Greece.  The Greek budget has been cut substantially since 2009.  Government expenditure as a percentage of GDP dropped from 54% to 50%.  Yet debt to GDP rose from 120% to 165%.  That is because the economy has been contracting at a rate of 5% per year since about 2009.  This led to the economy contracting from $347 billion to $305 billion from 2009 to present, and their economy is still contracting[i].  So, austerity did not make their debt more manageable.  It did however cause irreparable damage to the state and its future economic prospects.  Even with the effect of the debt write-down (default), and with austerity measures in place, it is estimated that in 2020 Greece will have a debt to GDP ratio of 120%.  In other words, they will be where they were when the austerity measures started.  We should also remember that the 120% ratio takes into account the assumption that the global economic situation will be “business as usual”, which I personally think is wishful thinking.
Despite the example of Greece, and the disastrous side effects of austerity in parts of Eastern Europe, we are still told that the austerity formula will work in current circumstances.  In order for it to truly work however, for the short run and the long run, we would have to see the following:

For the short run, austerity measures would have to have a smaller effect on economic growth, than what we have seen in Europe so far.  In other words, we would have to continue expanding GDP, even as cuts in government spending are implemented.  At the very least, the debt to GDP ratio would have to go in a better direction than it would if we were to do nothing.  In the case of Greece, as well as Eastern Europe, that clearly has not been the case.  In most of these examples, debt to GDP ratios worsened considerably, even as public sector jobs wages and benefits were cut, and pensions, health, education and infrastructure services were scaled back.  In the absence of the ability to shift consumption of one’s output of goods and services to other countries, as is the case now, since the whole world is experiencing difficulties, austerity has the potential to throw the economy in a vicious cycle that may go on until the end result will still end up being default.

In the long run we need to retain certain aspects of our social fabric that is meant to keep us adapted to competing in the modern economy.  We need to continue to provide potential investors with infrastructure, both human and physical.  The human infrastructure comes in the form of a well educated, skilled, healthy and dependable workforce.  The physical infrastructure of course needs to provide for transport, energy, and communications.  A post agrarian, consumer driven economy, which is what we are, needs to have a basic social safety net in place to allow the consumer to have the confidence to consume   If these crucial elements that make up a modern economy are overly neglected as a result of austerity measures, there is no point to doing austerity in the first place, because the end result will be the same as eventual default.

Is spending like there is no tomorrow the answer?

            If one listens to the likes of Nobel Prize winner Paul Krugman, and renowned economist Joseph Stieglitz, you would think that all we ever had to do to keep the economy from reaching the sorry state it is in, would have been to keep the foot on the accelerator, and continue with fiscal and monetary stimulus[ii].  Lucky us, that we now have major western economies that tried both the conservative austerity program, and the more left leaning policy of stimulus, since the 2008 recession.

            US budget deficits never dipped under the $1 trillion mark since the financial crisis, and there is a sense that even now that we are expecting measures enacted in the past decade, such as tax cuts and spending programs to expire this year, as well as agreed to cuts to kick in as a result of Washington politics, something will come along to prevent these measures from happening.

            The US economy has been growing at a decent pace in the past three years in comparison with many EU countries that were either forced, or chose to go down the road of austerity measures.  This however is a misleading situation, because while the economy is expanding at a rate of about 2% per year, the deficit is at 8% of GDP.  If they were to cut the deficit to about 5%, surely the US would enter a recession, while a 5% deficit is still rather high by historical standards.  Paradoxically, the rate of deterioration of the debt to GDP ratio might become worse than it is now[iii].

            So, one would think that the answer is in allowing deficit spending to stimulate the economy until the private sector can take over the role of economic leader, and then government can cut back.  Problem is that as we can see, the private sector cannot fulfill its expected role.  If the US has not been able to get back to solid private sector growth, which would allow it to start winding down measures to stimulate the economy, and start cutting the deficit after four years of almost 10% budget gaps, will the situation ever go back to normal?  The other important question is how long the market will tolerate continued heavy borrowing, before it imposes austerity measures?  In Europe it already happened for some countries that the market said enough!  In the US, there is probably about a decade to go before the market would suddenly turn against the continued issue of huge sums of bonds, mainly thanks to the US dollar’s privileged status as the main reserve currency around the world.

            Some argue that we only have to wait for the bad credit to be flushed from the system before we can have a self sustaining, private enterprise driven economy again.  Reality is that high commodity prices, which led to the declining health of the financial economy, still persist.  Mature economies, which cannot grow as fast as emerging economies were in fact more vulnerable.  Even though commodities make up a much smaller percentage of GDP than it does in developing economies, the much slower pace of growth, meant that the effect of commodity prices crowding out demand for manufactured goods and services, would have been much more severe in the absence of market and policymaker reaction to flood the economy with credit.  That helped us along until 2008, but now the party is over, and even though we do not want to face reality, we should, because there is no other way.

Broken and outdated Ideologies:

            When dealing with the current crisis, the main game in town is the much bellowed duel of the two main ideological ideas, of left and right.  The political dynamic shaped the argument into a choice of austerity versus stimulus.  As I mentioned however both ideas are irrelevant to the actual problem we are facing.  Nevertheless, as we saw in the weekend elections in France and Greece, we continue to be offered one of these two ineffective choices as directions forward.  We will see this play out later this year in the US, as well as many other countries in Europe.  How long we will go on being deceived by arguments by either side? I don’t know!  What I do know is that in the absence of us dealing with the actual problems that caused our economic stagnation, we will eventually suffer enough economic damage to cause a complete and irreparable collapse of the western world.

What we really need:

            There is only one cure to the problem of excessive demand on our global resources, and that is the proposal I made for a standardized global trade tariff to be implemented.  We need to get more value out of the commodities we consume, and the only way to achieve that is to have a mechanism in place to promote a return to the durable goods economy.  The market, if left unguided, will not do that for us, and neither will legislation enacted by individual states.  We now live in a global economic environment and we therefore need global scale solutions.  What we get instead is the endless and useless debate whether we should choose austerity or stimulus.



  1. kudos...well written and argued...and a intelligent and pragmatic solution...

    1. Thank you. I am pleased to hear that there are people out there, who can apreciate ideas that do not necesarily come packaged, like cheap meat into sausage casing, which is what the ideological elites tend to feed us lately, and unfortunately we are buying it.