...against fictions and other tall tales

Sunday, 2 October 2011

Stephen Harper, David Cameron and the illusive dream of austerity

Last week, Canada's Prime Minister, Stephen Harper, and his British counterpart, David Cameron, joined forces to urge world leaders, especially those of European nations, to embrace austerity as a way to avoid tipping the world economy into recession.

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


  1. Excellent analysis and recommendation Circuit. I was wondering when you'd take that rogue wave!!! Fine moves (nod!!!)

    Highlighting the household debt predicament is fundamental to any approach to resolving the current slowdown and revitalizing the economy. The backstops (nod) from BIS,and IMF suffice to make the PC question current or impending austere policy options. As an old friend of mine (juo) would have said, 'Can anyone not understand that's it rubbish!' He innovated on Eric Hoffer's famous: "An empty head is not really empty; it is stuffed with rubbish. Hence the difficulty of forcing anything into an empty head."

    Circuit, it is unreasonable to squeeze Canadian households any further than they have already been exposed to. It's time to give families some ray of light through the overcast.

    I am very surprised that Prime Minister Harper should have professed the austerity narrative when all enlightened policymakers and pundits in the US and Canada caution the approach. Or is Parliament STAFF so intellectually depleted that it's misreading signals, and getting their timing wrong.

    It may just be that time for the PM and the PC to calibrate advisors and some of the DM and ADM's responsible for this farce. The austere logic is so unreasonable at this time that it warrants PM and Privy Council to reprimand the culprits. Mr. Harper is much more brilliant than the semblance of the rhetoric attached to him.

    As for Mr. Cameron, so what? Before giving lessons to the world, let the British PM take his lessons home and test them. Once tested successfully, we'll consider them. Until then, Mr. Harper must gently open the taps, and the BoC loosen the valves. History will not be gentle this time around if fiscal accommodation in terms of govt spending is lent a deaf ear.

  2. Great set-up circuit, well presented and very well argued. When it's time to melee, you engage the narrative courageously. I think my friend swells is a tad too modest. It was the perfect time for PM Harper to lodge caution against the EU smaller members, as a quasi-caution to its bigger members. After all, we are currency issuing sovereign. But I agree with swells that the timing was inappropriate; it can actually backfire on Canada. Crying Wolf, these days, is asking for the spotlight and that's not what Canada needs right now. Certainly, PM Harper does not need to be perceived as being overly intransigent. We need markets; we are sellers!

    You outlined the need and the urgency. I'm certain many are considering the same options.

    Your nod to Boulding is much appreciated, I can assure you. He was by far the most brilliant of them all. Cecchetti is a good piece, and Alesina & Ardagna very pertinent. Good architecture on the set-up.

  3. This is a great column. Thanks again circuit for making economic policy simple for everyone. I agree with jh and swells, PM Harper is a brilliant tactician and I don't think he really believes in austerity at the moment for Canada. However, although it may be the politically correct thing to say in Europe, it is not the politically correct thing to hear in Canada. Someone misread the clock. As swells and jh, I'll give the PM the benefit of the doubt, and like Circuit, I believe Mr. Harper has already reconsidered austere policy.

  4. You guys are pessimistic! If it's that bad, why isn't anyone else seeing it, or doing something about it?

  5. Richard Plankett, Halifax3 October 2011 at 08:59

    I agree, what is government waiting for? The squall with a tsunami aftereffect. We've had enough of those in the Maritimes. On the other hand, I agree, Mr. Harper will not let Canadians down.

  6. Richard, KP: I hope you guys are right. His minorities were alright. But I think it's unlikely that the PM will revert back to stimulus. The reason, I believe, is political. There will always be individuals who think cutting program expenditures is the right thing to do when 'times are tough'. As for the possibility of changes within the higher echelons of the public service, I believe there is some merit to that idea. I like Swells' propositions. How about placing someone high at the Dept of Finance who's read Boulding, for instance (nod JH).
    Anon: It's hard not to be pessimistic. Unemployment has been too high for too long. And it's climbing! However, there are many experienced and enlightened politicians in the Commons. It's time for constituents to inform these good people of sensible policy options to move forward. I would even venture that two of the main parties right now are dying to hear for new ideas and innovative policy options.

  7. I agree with the UK Guardian's Jonathan Portes: http://www.guardian.co.uk/commentisfree/2011/oct/05/david-cameron-household-debt

  8. Again circuit (nod!!!), you are on course, decisively and appropriately, like the Bluenose!

    I had the distinct pleasure to read the speech by Mr. Cameron:


    Apart from being a preambular apology for his government's pending failure (which he openly admits: "I know you can't see it or feel it"), I could not help the considering the wit that some of Mr. Cameron's more figurative maxims generate.

    By cutting deficits "We can turn this ship around..." Of course one can turn the ship around, and force it into the squall with terrible casualties, social and economic.

    To decry England's lack of fight, the Prime Minister intones the popular "Remember it is not the size of the dog in the fight, it's the size of the fight in the dog." In this case, when the 'canis lupus familaris' is shadow-boxing, the motto is quite futile and could turn messy.

    In fact, so much of the figurative topoi are not appropriate that one is compelled by sympathy for the Prime Minister to search for an accommodating context.

    One finds the very reasonable parenthesis when Mr. Cameron formulates his Party and alliance's refusal to join the Euro. "We will never join the Euro" saith he, since it's the monetary union which is at the root of all continental Europe's malaise. "Because we are not in the Euro, we can lay those foundations ourselves on our own terms, in our own way." How True!!! The answer is right in front of you.

    Of course, any sovereign issuer can resolve its problems more easily and with greater compassion than a non-sovereign issuer. Unfortunately, "The Answer is Right in Front of You" transcended the staffers' intuit and they penned the 'typo' 'reduction' instead of 'spending' after deficit.

    If Prime Minister Cameron wishes to subject the United Kingdom to Beta testing, then it is the prerogative of the Government to do so and "shoot oneself in the foot", but they should not do it at the expense of the people. That is the ultimate consideration of a Parliamentary system: put it to referendum. Do we cut spending and cut jobs, or do we spend and create some jobs.

    I can feel and see the time!

  9. it's unfortunate that mr. cameron should indulge in misplaced and ill-placed irony. never has a serious british prime minister singled out the United States so unnecessarily as in his speech: "Even mighty America is being questioned about her debts" as a benchmark for one's own shortcomings.

    i can't imagine a United Kingdom under cameron with problems like America's. what taste? Heaven spare the uk.

  10. JH, you got that one right. His was a skating speech: trying to justify their actions by using whatever piece of information that remotely sounds relevant. My interest in the UK is an extension of my interest in Canada. Cameron's use of our experience during the 90s is totally misplaced.

    B, the ship is turning indeed. And you are right, the dog is shadow-boxing, but without having a clue who's its next opponent. The only positive element in all this is that a number of news commentators in the UK appear to remember the lessons of Wynne Godley. Hopefully MPs and their staffers are listening.

  11. I thought we would stick to Canada and the United States, now we follow the United Kingdom, including detailed speeches. Can't we just find a niche or is FRB falling into globalization.

    The problem is that it's all great.

  12. Trevor C. Boston MA6 October 2011 at 19:05

    I have no problem with expanding the sphere of influence and topics of discussion. It's impossible to isolate economic issues in this global market. Nations are ripples to each other, ripples that are becoming more and more visible and unfortunately more difficult to contain.

    The comments on PM Cameron were pertinent. There's a lot of US-bashing in European political and financial circles. His was not the worse, although the subtlety was annoying coming from the GoB. Merkel's was pretty rough; and now does she rant?

    Our shoulders are wide, but it's an irritant to experience from whiners who are in a worse position than North America.

  13. Nod again circuit, for knowing how to chair a good conversation. I'll abstain from commenting on Mr. Cameron's rhetoric. Your readers are doing very well in parsing the text.

    However, the issue of whether household debt is crucial to recovery is challenging. One can suggest that it has no intrinsic merit, and less so, in a recessionary context. The underlying assumption for one school of thought is that household debt is analogous to sovereign debt. It should be reduced. That is not the case; the parameters are entirely different. Neither should be just reduced in a recessionary context; they should managed.

    If the components of the household debt are real expenditures in sectors not covered by public expenditure, it is certainly warranted. The spinoff supports diversification of stimuli and a broader sectoral range of recovery. Intensive double-dip spending in same limited sectors are marginally ineffectual.

    The other caveat is that household debt, by nature of its liability, unfortunately constrains the ability of government to implement optimal tax policy which in some cases could constitute the most reasonable political solution to the situation, with respect to its decision to redistribute revenues throughout the system as deemed optimal.

    Household debt is non-desirable in the case of the unemployed household. Not only is it morally repugnant to endure the effects (and this goes beyond family and bankruptcy legislation)it is economically ineffectual and counterproductive. The costs of subsidizing the dual negatives is socially unacceptable. That is the fundamental reason why maximum employment is the most critical goal of correct fiscal and monetary policy. All other alternatives are 'rubbish' as one of your readers has intelligently characterized the consideration.

  14. Globalization indeed, Coleen. You said it. And Trevor described it well when using the analogy of ripples. These take many forms. Check this out: a former Canadian PM acting as an adviser to the British PM (on how to re-create the impossible...see my post above); the current US Secretary of the Treasury participating at the Eurozone Finance Ministers' meeting (nod GC); the US central bank providing assistance (an understatement) to foreign CBs; every news outlet covering the problems in Europe...the list goes on. But the ripple I find most disturbing is the idea that the default of a country whose total output represents less than 2 percent of the Eurozone's GDP has the potential to take down the whole thing. From a risk management standpoint, there's something very wrong with this picture.

  15. Great comments. I particularly like the insight of one commentator, MI, that since household debt and sovereign debt are quite different, they must be managed. It appears to me healthier than neglecting them, or dismissing them as non-problematic. Anyways, the sovereign can print and not default. As far as I know, households can't do either yet.

    I also appreciate your snippett on Cameron. The correction update by Cameron's people is a joke. Some of your readers keep targeting staffers. Now I understand why. No one gets away with fiction in FRB. Good stuff.

  16. MI, you make an excellent case in favor of full employment. The notion of the diversification of stimuli is one that I find very important for our current predicament. I assume that the household component takes an especially important role in situations like ours (say, in North America) when the corporates are sitting on the sidelines. Full employment brings them back in the game. As economist Bill Vickrey once said, "it is the economy that needs to be balanced". Full employment enables the return of such a balance, as it creates the conditions for a healthier dynamic between the household, corporate and government sectors.

    @Rick, I too like MI's comment on managing debt. Cameron simply went too far by saying HH debt needs to be eliminated (as if households can achieve this without macro management...). I think Cameron is trying to instill a moralistic element to his economic policy. Since his austerity program doesn't seem to obtain the intended results, it is impossible for him to argue in favor of this approach using empirical methods. That's why he's now edging toward a moral basis for debt reduction. Not only is this bad policy, it is a mistake to think this way.

  17. Circuit, you put a smile on swells's face and a nod on MI by mentioning Bill Vickrey. one can hear chicago grumbling about that remarkable gadfly.

    but managing the micro and macro deficits is not the same as balancing budgets: Vickrey wouldn't like that and MI certainly wouldn't either. Vickrey professed the management of economies and deficits. and like H. Simon contended that the praxis of managing the latter deficits requires a brilliant public administration.

    aside from the explosive underlying moral hazards of fiscal policy with respect to Households a great Treasury must be alert and sensitive to the global 'ripples' coming its way. the process of fiscal allocation and redistribution of stimuli is so delicate that it is no surprise that in the history of public administration there has never been a great secretary of the Treasury, or equivalent.

    i make the point in reference to your interest in the uk. consider that both, i emphasize both messrs osborne and king are edging towards keynesian positions in their optics. King in fact smacked the pound when he expanded money supply and Osborne certainly informed, 'seems' to be aligning the Exc.'s fiscal policy accordingly. one is astounded that conservative staffers and pundits are opaque to boe's and the exchequer's positions contra pm cameron's public disclosures. if the government manages the british economy like cameron's inner circle manages his public relations, it shall be cataclysmic.

    MI's temptation to extend moral offense to public policy is very audacious. it must be a sign of the age (lol). but then the restraint- limiting the moral offense to unemployed households. that, in my opinion, is already a daring step.

  18. FRB is the best kept secret in the system. It's the best read in a nutshell.

  19. Thanks C! I'll just add that the comments on FRB are some of the best I've read. Take the comments to this post - the interventions are a very concise rendition of the nature of sound fiscal policymaking.
    @JH: I've also noticed a shift in thinking in UK at the officials level. The BoE these days provides an interesting counterweight. Also, is there any particular work by Simon that you would recommend on this topic?

  20. indeed circuit the QE King approved last week was, i assume, again i assume, a three-way-play, with the bofe buying g-debt (bofe can't purchase corporate bonds because of default risk and other contingencies known to all,) and instaed, the Exch picking up the alleviative money to rechannel to corporates. Osborne was certainly cognizant of the decision and the mere exercise demonstrates that Osborne is on a transformative trek that great leadership undergoes when it reneges on personal ideological preferences to advocate pragmatic solutions to public needs. this is very representative of a change in mind-set that reflects sophisticated insights in functional finance and satisfices the need to stimulate growth in corporate sectors and induce employment. both V & S would be pleased. however, more significant along this same line is Osborne's decision to shelf the environmental platform professed a while ago, and de facto renounce cameron's green conservative image. the imperative to do so at this moment of crisis is the test that at least Osborne, and certainly King, have rethought, a friend of mine would refer to this moment as the KEHRE, fiscal and monetary policy. the important lesson to be retained is that keynesian guidelines are appropriate for keynesian settings, each setting relative to the sovereign's domestic and external requisites. the world economy is in such a keynesian setting.

    as far as suggestions, you don't need any. however, i still wonder at the insights in Simon's Administrative Behavior 1947 or '48? or newer eds. the Simon classic on my shelf is the Models compilation of papers Vol I & II,
    Vol I (Economic Analysis and Public Policy, late 70s early '80s) is endearing because it contains the classic on bounded rationality...my experience with Simon is that he is challenging because he works by analogy all the time. a brilliant thinker. he only serves the ball. the ball is always in your court waiting for your move. with Simon, then insights are always your moves. he compels one to out-think oneself all the time. he is as much fun as he is work.

    finally, many pundits are pointing to canadian employment stats. i suggest the interpretations are misleading, and the stats require a good analysis.

  21. JH, I enjoyed your take on Herbert Simon. I've spent many hours reading and referencing his work. He's highly quotable, to say the least. Indeed, a brilliant thinker. Your comment regarding his use of analogy is interesting. I never thought about it that way. That said, I've always thought the study of public policy benefits from such an approach to problem-solving. Recognizing when to apply appropriate action is a skill (using precedent and/or tried and tested practices) that policymakers should aim to cultivate. (I'm reminded of comments to my July 8 2011 post on Volcker).
    As for unemployment, I'm afraid I'm not as optimistic as some commentators have been after last week's figures. When I look at unemployment during 2011Q3 as a whole, I don't see much positive. Also, I foresee unemployment climbing during Q4. I expect corporates to cut costs after weak quarterly profits. Governments will do the same in earnest as plans to cut personnel will get implemented. In my view, the magnitude of the coming increase in unemployment in 2011Q4 and 2012 will depend on the housing market. House prices reached a new, all-time, high this summer. I don't think it is sustainable. The workforce associated with this sector will surely get affected by the upcoming slowdown/correction. Employment levels in housing have increased markedly in the last year and a half. On the 'upside', HH indebtedness continues to fuel economic activity, which might moderate the effect on unemployment.

  22. I hope we are all wrong on unemployment, but the last figures, aside from an ephemeral seasonally adjusted stat, manufacturing is down! If no one considers the specific and its effect and reacts aggressively to it, then circuit, you are correct: Q4 and especially Q1 &Q2 of 2012 will be very bleak.

    Happy Thanksgiving, but for many it's not a celebration.

  23. I agree that's it's very difficult to see through the unemployment rate and monthly employment figures. However, the cautions by jhcraw and swells confirm the ongoing uncertainty among the interested public that the employment gains announced last week require at least some reservation before turning taps off on spending. Certainly, the fact that manufacturing numbers are down is a negative on suggesting that the economy is well. The only semblance of improvement is the construction figure yr-yr. I have a tendency to neglect service sector improvements because they are too volatile to support longer term positions. I am prone to agree with circuit, jhcraw and swells that the next three quarters will reveal the true of the employment figure (unemployment rate) in Canada. I also surmise that as the loonie softens, we will be in a position to re-shore some of the manufacturing activity that had abandoned us years ago.

    It is a difficult situation to manage for government and BoC, but I would not hold back decisions on public spending. I would assume the worse, rather than indulge in the 'ephemeral'