Will Hopes for European Austerity Be Deflated?Published: June 23, 2010 in Knowledge@Wharton
Following Greece's pledge to reduce its debts dramatically through a combination of government spending cuts and tax increases, others, including Spain, Germany, France -- and just this week, the U.K. -- began the march toward austerity. While many question whether a country like Greece can make good on its promises without resorting to debt restructuring, the bigger question is whether the austerity measures will actually work as proponents indicate. "These countries have put themselves in a corner they cannot get out of," says N. Bulent Gultekin, a professor of finance at Wharton. Not unless they cut spending, raise taxes or both -- which is what austerity amounts to.
Through the spring of this year, concern mounted that several European countries would experience increasing difficulty in meeting their debt obligations. Nations had their credit ratings downgraded; interest rates on sovereign debt shot upward, and the euro came under intensifying pressure. Finally, on May 10, European Union (EU) finance ministers, along with the International Monetary Fund (IMF) took decisive action, establishing an emergency aid fund worth $930 billion (750 billion euro).
The assistance package was announced much later in the crisis than many might have considered ideal. On April 27, ratings agency Standard & Poor's downgraded Greece's sovereign debt to junk status. The next day, yields demanded of Athens on 10-year government bonds leaped to 11.24%. But Greece's balance sheet had been steadily deteriorating for years. The country's budget deficit this year is expected to exceed 10% and its debt-to-GDP ratio hit 112% in 2009, and it is forecast to worsen significantly over the coming years. Meanwhile, Greece's economy is projected to contract by 4.6% this year, after averaging greater than 4% annual growth between 1998 and 2007. When it suddenly became clear that significant portions of Greece's debt had been hidden from view, the country was forced to acknowledge that its financial troubles had gone from serious to acute.
As a result, on May 2, the country accepted from the EU and the IMF a bailout package worth $146 billion dollars. Along with the funding came strict conditionalities imposed by Athens' European partners, and in particular by Germany. Most prominent among these was a pledge by Greece to reduce its annual budget deficit to less than 3% of GDP by 2014, something that will require spending cuts of 5.3% of GDP, tax hikes to the tune of 4% of GDP, and economic reforms that, it is hoped, will encourage economic growth.
Since Greece accepted its bailout, no other European country has been forced to draw on emergency funding, though the EU and the IMF -- just days after rescuing Athens -- announced the $930 billion standby aid fund for fiscally troubled countries in the euro zone. Any nation that accepts the money, however, will face austerity measures much like those imposed on Greece.
Cutting to Grow
For some financially distressed European countries, the question may never have been whether austerity would become necessary. The more pressing questions, experts note, most likely concern scale and timing, and whether austerity would prove adequate to the scope of the problem. In an ideal world, an indebted country would simply grow its way out of the problem. But in the case of Greece, for example, poor economic growth potential is widely viewed as a large part of the reason it faces a dire fiscal future.
A second approach would be to reschedule or restructure the debt burden -- in effect a negotiated default -- but this solution is highly problematic. "Restructuring would be rational in some cases," Gultekin says, "but in that event, markets just freeze. Markets get very upset." A third choice is to devalue the currency, which can also invigorate an economy by making exports cheaper. But the troubled countries of the euro zone, which do not control their own currencies, would have to take the radical step of leaving the zone in order to make devaluation possible.
With these options either unavailable or too unpalatable, troubled countries must seek bailouts or "the kindness of strangers," notes Richard J. Herring, a Wharton finance professor. But such aid packages are almost certain to involve austerity measures. Though the concept behind austerity is simple, implementing austerity is not. The first challenge is that stakeholders -- especially labor unions in Europe -- tend to resist austerity measures quite strongly. Such conflict has been widely evident in Europe over recent months. On May 5 in Athens, violence erupted during protests against spending cuts of $38 billion that involved reducing pay for public-sector workers, raising taxes on cigarettes and alcohol, and setting stricter retirement rules. Three deaths resulted, though the legislation passed the next day. French unions on June 16 announced plans for a June 24 strike to protest the government's intention to increase the retirement age from 60 to 62. Spanish unions have threatened a September strike to protest measures such as cutting public-sector wages by 5% and reducing severance pay for fired workers.
The second challenge to implementing austerity is that fiscal problems, unsurprisingly, tend to present themselves most acutely at inconvenient moments in the economic cycle -- during recessions and weak recoveries. That is when government expenditures generally run high because of greater public need for unemployment compensation and other services. Simultaneously, tax receipts suffer because of slow economic activity. The result, experts say, are manageable fiscal imbalances that can suddenly become unmanageable. Austerity plans are usually announced at just such moments -- but it is an unfortunate characteristic of austerity measures that they reduce aggregate demand, potentially worsening a nation's economic struggles or even contributing toward a deflationary cycle. Many economic historians believe such policies helped lead the world into the Great Depression.
The Big Debate
"There is a big discussion going on now about whether austerity is wise [or] whether the recovery might be delayed by these measures," notes Wharton management professor Mauro F. Guillén. Prominent among those questioning the wisdom of austerity in the current economic environment is Princeton University economist Paul Krugman, who has used his column in The New York Times to argue that countries such as Germany and the United States will only exacerbate unemployment by cutting spending while the global economy remains so weak. Taking the other side of this question is Alberto Alesina, an economics professor at Harvard University, who says: "Austerity on the spending side will have a very limited effect on growth, if any at all."
No matter which side of that debate one takes, another obstacle lies in the way of enacting austerity measures -- its association in the minds of many with widely criticized IMF policies of an earlier era. During the Asian financial crisis of the late 1990s, for example, the IMF advised desperate countries such as Indonesia not only to raise taxes and cut spending, but also to hike interest rates and shut down banks. In Herring's words, the IMF applied "a cookie cutter approach that they had learned in Latin America and that did not fit the problems in Asia."
Such measures, according to Christian Weller, a public policy professor at the University of Massachusetts, now have been "discredited by those who follow these issues closely." The Latin American debt crisis of the 1980s largely involved heavy government borrowing in foreign currencies. But Asian governments, Weller notes, had practiced strong fiscal discipline and sound monetary policy, yet the IMF imposed on them "austerity measures that arguably made a tough situation worse." The Asian crisis, and also the crisis in Argentina in 2002, involved largely private borrowing in foreign currencies rather than public borrowing. The crises came when new foreign loans became scarce.
Even the IMF no longer advocates the measures it used in Asia in the 1990s and has since "changed its approach to conditionality," says Uri Dadush, director of the international economics program at the Carnegie Endowment for International Peace. "They have adopted a minimalist approach." Indeed, Dadush says, the most stringent conditions imposed on Greece when it accepted its rescue package were insisted on not by the IMF, but by other European nations, including the Germans who "were under tremendous domestic pressure to punish Greece."
Still, distrust of the IMF persists. Gultekin points out that last year, when countries such as the United States were initiating unprecedented stimulus measures in response to the global financial crisis, the IMF advocated no austerity. Now, with countries on the periphery of Europe struggling, "the IMF has reversed its position. So people can be cynical about the IMF." This cynicism may represent an obstacle not only to the imposition of austerity but also to the adoption of other reforms that many economists say are needed if the fiscally troubled countries of southern Europe are to get their houses in order. Primary among such changes are labor market reforms such as reducing high severance payments and eliminating rules that make it extremely difficult to fire workers. In Greece, Portugal, Italy and Spain, notes Gultekin, "firing someone is so difficult that people are unwilling to hire." This acts as a drag on growth -- which is bad in itself, but also troublesome in fiscal terms because, as Alesina says, "when we talk about debt-to-GDP ratios, the numerator has to go down and the denominator has to go up."
Will It Work?
Will austerity measures prove adequate to the fiscal problems facing countries in southern Europe and beyond? Experts say the answer seems a qualified "yes" -- with the possible exception of Greece. The fiscal crisis in Greece is just as severe as advertised. The IMF projects that the country's debt-to-GDP ratio will register close to 150% by 2012 -- even if very strong austerity measures are imposed. Some, including Dadush, find it difficult to imagine how Greece can escape its debt problem and believe that "it is the one country most likely to end up with some sort of restructuring or forgiveness."
In the other troubled countries of southern Europe -- Portugal, Spain and Italy -- the fiscal pressure is significant, but less severe than that afflicting Greece. Of those three, Portugal is in the worst bind, and is considered the country after Greece most likely to seek debt restructuring. Spain's problem is real -- the unemployment rate there hit 19.7% in April -- but according to Guillén, its "budget deficit is not that bad. It is something that can be addressed, even though unemployment is so high." Spain has already begun taking ambitious steps toward redressing its fiscal imbalances, first by pledging to reduce its primary budget deficit to less than 3% by 2012, compared to 9.9% in 2010, and second by making initial moves towards labor market reforms. Italy, meanwhile, is in the least severe position because the nation's deficit, says Dadush, "has stayed within reasonable bounds."
But fiscal problems in the wake of the global financial crisis extend far beyond the euro zone. In Britain, Prime Minister David Cameron announced just weeks after taking office that painful budgetary decisions lay ahead. On June 22, his administration detailed a plan that includes $168 billion in budget cuts and a significant increase in sales taxes. Average government department spending is to be slashed by 25%, while the value added tax will rise from 17.5% to 20%. Numbers indicate that Britain's ability to confront its debt exceeds that of many other countries, however. For example, its debt-to-GDP ratio, while high at about 69%, is not quite panic inducing. Just as important, Britain controls its own currency, meaning that in a pinch it could devalue. And the country also maintains a high reputation for governance, giving investors confidence that, no matter happens, they will get their money back.
Looking beyond the European continent, experts point to two nations as standing out due to enormous debt concerns: Japan and the United States. Japan at first glance would appear to be the most fiscally troubled major economy in the world. Its debt-to-GDP ratio comes in at an eye-popping 219%, and new Prime Minister Naoto Kan made headlines on June 11 by suggesting that the debt burden could one day create a Greek-style crisis. For the moment, however, observers outside Japan do not seem enormously troubled by the country's fiscal position. This is largely because its debt is denominated in yen and is funded overwhelmingly by the Japanese themselves at extremely low interest rates. Therefore, notes Takatoshi Ito, professor at the Graduate School of Economics at the University of Tokyo, "When a fiscal crisis occurs in Japan, the rest of the world will be affected, but to a much lesser degree than by the subprime crisis [in the U.S.] and other such crises."
Still, for a country carrying such mammoth debt, what sort of austerity measure could possibly address the problem? Ito prescribes gradually raising the value-added tax, currently set at 5%, to 25%. According to Dadush, Japan is under no immediate threat of a credit crisis: "They still have some room. But if three years from now they are in the same situation that they are in today, they are going to be in trouble." He believes the same is true of the United States, a country whose finances are under considerable stress because of reduced tax receipts resulting from the global financial crisis, as well as stimulus spending and money used to fund the wars in Afghanistan and the Middle East.
But the most serious long-term strain on U.S. finances comes from rising expenditures on health care, creating a fiscal picture that "does not look good at all," says Kent Smetters, a Wharton professor of insurance and risk management. "The shortfalls are absolutely enormous, specifically in the Medicare system." Smetters points out that projected fiscal shortfalls represent, in present-value terms, almost twice the value of the country's capital stock -- its "lands, buildings, homes, and publicly and privately held companies." But as with Japan, investors have to yet to display much nervousness about U.S. debt. Gultekin notes that the U.S. dollar's status as the world's reserve currency "provides tremendous flexibility."
Although countries and Europe and elsewhere have gotten themselves into trouble through heavy borrowing, "you try to fix things, and you learn," Gultekin says. "Learning does not happen in democracies, or much of anywhere else, until people experience problems for themselves."