Europe's Austerity Pipe Dreams

Economic history suggests that Europe won’t be able to fulfil its budgetary pledges. A comprehensive study by IMF researchers shows: In an environment of weak economic growth austerity programs usually fail.

Don't worry, probably he won't be able to deliver, anyway. (Photo: Mark Ramsay via Wikipedia)

Austerity has become very fashionable these days in Europe. Greece has committed itself to one of the most ambitious austerity programs in modern history. Last week, the government in Athens pledged to ax even more jobs, raise more taxes and cut more expenditures. Italy, one of the most notorious debt nations around, wants to balance its budget in two years time. In France, Nicolas Sarkozy forced his ministers to cut short their sacred summer break. Within one week’s time, they had to propose new consolidation measures. Within two years, “la Grande Nation” wants to cut its social security deficit by 40 percent.

However, these challenging promises should be taken with a grain of salt. It is highly questionable that European governments live up to their pledges. When it comes to austerity programs, dreams and reality quite often are worlds apart. This message can be gleaned from a recent comprehensive study conducted by IMF economists.

In a series of unique case-studies a research team lead by Paulo Mauro, chief of the IMF division “Fiscal Operations”, analysed if and when governments were able to fulfil announced austerity programs. The authors also tried to work out why certain budgetary consolidation programs foundered.

Their results are rather sobering. On average, EU countries missed their targets significantly. EU governments announced 66 austerity programs and pledged cuts cuts of 1.7 percent of GDP on average. However, they were only able to deliver slightly more than half of this.

The study entitled “Chipping away at public debt” has recently been published by Wiley (304 pages, £30.99 / $45 / €36) and is a must read for every policy maker involved in fiscal policy. As Paulo Mauro rightly asserts in the introduction:

“Although today’s circumstances may be different from those experienced in the past, history may nevertheless provide useful guidance.”

The economists looked at historical examples from seven western countries, among them the United States, the UK, Germany and Japan.

In post-war Germany, for example, four different governments announced austerity programs. The success rate is mediocre. On two occasions (1981-85 and 2003-07), the governments were able to more or less live up to their promises, while they failed in the two other cases (1976-79 and 1991-95). Both times the targets were missed for the same reason: an unexpected recession thwarted the plan.

It’s the economy, stupid!

Examples from other countries confirm this pattern. Weaker than anticipated economic growth is the most common reason for fiscal consolidation plans to falter. First and foremost, this is due to the fact that tax revenues are strongly determined by the business cycle:

“The most important determinant whether fiscal adjustment succeed is economic growth. (…) When growth falls short of expectations, weakening revenues are frequently a source of deviations of fiscal outcomes from targets.”

Another reason why politicians find it hard to fulfil their austerity pledges in a recession is that quite often political priorities shift. When the economy tanks, consolidating the budget is not the most important task anymore. Boosting the economy instantly looks more important. This, however, is a rather expensive endeavour as we painfully experienced in the last couple of years.

So let’s look at successful austerity programs. When do governments actually meet their consolidation targets?

Across different countries and decades, successful consolidation plans usually have a common feature, the research team finds out. They are driven by higher tax revenues, not by the cutback of expenditures. Spending less money seems to be much harder in reality than it is in theory: On average, only one sixth of all announced cuts really materialized later, as the economists point out in the book:

“Although plans envisaged cuts in the ratio of structural primary spending to GDP of 1.8 percent on average, actual cuts amounted to 0.3 percent. Revenues exhibited a converse pattern – exceeding planned increases over 1 percent of potential GDP”.

The idea that the austerity measures will quickly boost economic growth is highly delusional, as a different IMF research team recently showed in a paper entitled “Expansionary Austerity: New International Evidence” by Jaime Guajardo, Daniel Leigh, and Andrea Pescatori. The key finding of that paper is that the existing empirical evidence for expansionary austerity is seriously flawed. (I’ll discuss that paper in detail in a different blog post shortly.)

Besides a benevolent economic climate good communication is key for successful fiscal retrenchment. It seems to be impossible to do austerity against public will. Public support is decisive. “Politics does matter”, as the research team notes:

“What seems most relevant is (…) the broad public’s understanding of the need for adjustment, and its support for debt and deficit reduction and for the measures through which it is to be achieved.”

Interestingly, however, there seems to be no link between the parliamentary strength of a government and the success of austerity packages:

“Even politically weak governments can undertake adjustment if they succeed in shaping public opinion through reasoned arguments.”

For the euro crisis, most key findings of the book are not a good omen. Several governments are focussing on expenditure cuts that the voters despise. Additionally, economic growth in the crisis countries is feeble at best.

Judged by historical precedents, it does not seem wise to believe the austerity pledges of Berlusconi, Sarkozy and Co.

Most likely, they will turn out to be pipe dreams.

12 Comments

Filed under Economic Policy, Financial Crisis

12 Responses to Europe's Austerity Pipe Dreams

  1. Well, so Berluscuni is actually quite realistic to focus his program on higher taxes…

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  3. You can’t escape the automatic stabilizers. Once a government starts to walk down the austerity road they will kick in. Now matter what. What amazes me is that the people in IMF research departments and the IMF enforcers with boots on the ground seem to live on different planets and haven’t yet heard of each other.

    • Procopius Furioso

      Bingo! I don’t have the facilities to do serious research on the question, but my impression is that since its founding the IMF has always imposed counter-productive austerity measures on their victims. My impression has also been that their efforts actually extended the suffering by several years. Always. Without exception. If I am wrong I would like to have an example, but my belief is that there has never been a case where the IMFs required “solution” has worked. Here in Thailand, one reason Thaksin became the first Prime Minister in history to complete a full term of office was because he paid off the IMF early and kicked them out.

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  5. Unfortunately, Greece has no alternative to austerity as they are cut of from the debt markets. Until the primary surplus is reached, they will not get around.

  6. FloMo

    Not a big surprise. But the interesting question is: If even the IMF knows how economically useless austerity measures are – why are those measures imposed at all? Maybe because they serve other political goals: Privatization, social cuts, reduction of public expenditure for its own sake, putting pressure on wages, boostin income inequalites, and so on…

  7. I agree to FloMo. Well, the simple reason is that austerity measures help to avoid an assets levy. Both, austerity measures as well as an assets levy depend on the Social Capital, not on governmental action and IMF consultancy. Unfortunately Social Capital still doesn’t appear in the agenda of the Harvard dinosaurs of IMF, WEF and Worldbank.

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  11. Austerity will merely inflict unnecessary pain. It all comes down to trade imbalances. Once these are straightened out, capital flows will also even out. Even with the common currency, it is the fact that the borrowed money has been spent on foreign imports that cause the problem. If the money had not been spent on foreign imports, it would still be in Greece, and could be repaid.

    One way to balance trade is with ‘import certificates.’ For instance, Greece exports to Germany. For each euro of export to Germany it issues an import certificate to Germany, allowing Germany to export one euro of goods or services to Greece. Trade would then be balanced.

    This would to be phased in, on a schedule that would allow the Greeks to build up their economy. Eventually, Greece would issue certificates allowing the importation of say .9 euro worth of goods for every euro of goods it exported. It would then be a net exporter, and could begin paying back its debt. This will take many years, but it can be scheduled. Of course, much forgiveness must also be involved. Otherwise Greece’s debts would be insurmountable. See: http://anamecon.blogspot.com/2011/10/import-trade-certificates-some-problems.html

    Right now there is no realistic horizon for the problem to be resolved. Phasing in import certificates will provide that horizon, as well as clarify everybody’s attitude towards the problem. The Greek economy must grow, but austerity will cause it to contract, just the opposite of what is needed.