According to Harper and Cameron, cutting government expenditures is the only way to fix the national economies of Europe and the United States, and restore confidence in the market. Excessive debt, they say, are to blame for the current problems now affecting several European countries. And the best way to remedy these problems, they conclude, is for nations to deliver on their promises to impose austerity measures and implement budget cutbacks on government expenditures.
In my view, there are a number of problems associated with this course of action. Firstly, from a historical standpoint, it should be emphasized that austerity has been found to be associated with positive economic performance in only a minority of cases where it has been attempted. For instance, an IMF study authored by C.J. McDermott and Robert Wescott concluded that fiscal retrenchment was accompanied by improved economic conditions in only 19 percent of the relevant episodes occurring between 1970 and 1995 (1996).
Also, more recently, a study by Alberto Alesina and Sylvia Ardagna found that the combination of austerity and growth occurred in 25 percent of the relevant episodes recorded by the OECD between 1970 and 2007 (2009, Data Appendix:Table A2).
In other words, both studies demonstrate that the odds of successfully reducing public debt levels and achieving increased growth through austerity are not very good.
Secondly, austerity rarely leads to improved economic conditions solely as a result of fiscal retrenchment by government. Most often, successful public sector austerity campaigns are the outcome of the combined effects of monetary policy and exchange rate policy, as well as the positive impacts of external economic conditions.
For instance, Canada's experience with austerity in the mid-1990s could be viewed as positive largely because of the change in US exchange rate policy announced in April 1995. As I explained in a previous column, this change in US exchange rate policy
...resulted in the rise in the value of the US dollar against other currencies. The ensuing depreciation of the Canadian dollar provided a huge boost to Canada's exports, and helped Canada achieve several years of consecutive current account surpluses.In the case of many European countries today, austerity cannot benefit from changes in monetary and exchange rate policies given that the European Central Bank has no mandate to assist members of the European Monetary Union (EMU) in this regard. Also, given the weak global economic conditions at the moment, European nations cannot look to improvements in trade as a way to achieve growth.
Finally, there is something inherently odd about hearing the Canadian and British Prime Ministers scold Europeans with calls to stem the growth in public debt. As the subprime crisis and the ensuing recession have taught us, it is excessive household debt that ought to be the main preoccupation of governments right now. And when it comes to excessive household debt, Canada and the UK are countries with two of the highest household debt to GDP ratios in the world.
To be sure, it is true that public sector debt is currently a problem in many European countries. However, the problem is primarily the result of structural deficiencies in the EMU, not the result of excessive fiscal spending. These structural deficiencies have been known to many economists since before the EMU was even established. Thus, budgetary austerity in the Eurozone will do nothing to remedy the public sector debt crisis now affecting Europe. If anything, further austerity will likely worsen the existing situation (see Forstater, 1999).
On the issue of excessive household debt, the Bank for International Settlements (BIS) has recently estimated that a household debt to GDP ratio above 85 percent has damaging effects on growth (Cechetti et al., 2011). With ratios now at over 94 percent and 100 percent, respectively, Canada and the UK are well above the "safe" limit set by the BIS. Canadian and British policymakers should take note of this fact. (For more on ratio figures, see Tang and Upper, 2010:27)
Also, it would be appropriate to remind policymakers of the "counterpart principle" in government transactions put forth by economist Kenneth Boulding and others several decades ago (1958:169). According to this principle, all activities of government have opposite counterparts in the private economy. Thus, any decision by government to cut expenditures or increase taxation will have an impact on private sector income and savings.
In other words, for every dollar, pound or euro not spent by government, one less dollar, pound or euro gets added to private sector bank accounts. Similarly, for every additional dollar, pound or euro levied in taxes to reduce public sector deficits and debt, there is one less dollar, pound or euro available for the private sector to spend, add to savings or use to pay down private debt.
In a context of excessive household debt and weak global economic conditions, government austerity will most likely have serious deleterious effects on the balance sheets of households. Under such circumstances, austerity is not to be recommended.
To conclude, I strongly urge Messrs. Harper and Cameron to consider the above before continuing to praise the merits of public sector austerity.
Alesina, A and Ardagna, S., "Large Changes in Fiscal Policy: Taxes vs Spending", NBER Working Paper No. 15438, October 2009
Boulding, K., Principles of Economic Policy, (Englewood Cliffs: Prentice Hall), 1958
Cecchetti et al., "The real effects of debt", BIS Working Paper No. 352, 2011
Forstater, M., "Introduction", Eastern Economics Journal, Vol. 25, No. 1, 1999
McDermott, C.J and Wescott, S., "Fiscal Reforms that Work", Economic Issues, No. 4, November, IMF, 1996
Tang, G and Upper, C., "Debt reduction after crises", BIS Quarterly Review, September, 2010