Austerity measures and spending cuts are now a part of every day life for most Europeans. Once these fiscal policies were tolerated, but now public opinion has changed. Rita Lobo investigates how other countries have taken alternative routes to find a better solution
Recent months have seen the defeat of austerity-champion Nicholas Sarkozy and the election of François Hollande with his promises of growth for France. Anti-austerity riots and protests have erupted in Spain and Greece; Barack Obama and Christine Lagarde have joined the ranks calling for more growth stimulus. Anti-austerity catcalls have been echoing around the world, citing the enduring crisis in Spain and Greece and the ‘double-dip’ in Britain asconclusive evidence that austerity has failed.
Meanwhile, Greece and Spain continue in the seemingly irreversible downward spiral of spending cuts, reduced outputs, high levels of unemployment and inevitably, even greater deficits. At a recent EU summit, one of many, Lagarde emphasised the need to start moving away from austerity towards more structural reforms, saying: “The IMF [International Money Fund] believes that a determined and forceful move towards complete European monetary union should be reaffirmed in order to restore faith in the system because we see at the moment, the viability of the European monetary system is questioned.” But Angela Merkel once again put her foot down. She also resisted all proposals to provide relief for Spain and Italy from the rocketing premiums they now face in the market.
A growing number of economists and experts, from Paul Krugman to George Soros, have been denouncing the harm austerity measures have caused to the recovery process. Soros in particular has been pointing out that even if the eurozone manages to avoid disaster, a canyon is being forged between creditor and debtor countries. Austerity measures being forced on the so-called ‘peripheral eurozone countries’ is risking shunning them into the ghetto.
Like an overexcited child at a carnival, Krugman aims his air rifle at the balloon: a flawed monetary system that is sinking precarious economies like Greece’s. Austerity is not working, says the designated Keynesian-driver, it was never going to work. Krugman is especially critical of what he calls ‘the confidence fairy’; that is, the idea that austerity will somehow increase investor confidence and boost expansion. He blames a mixture of fundamental flaws in the euro system, namely “the arrogance of European officials, mostly from richer countries, who convinced themselves that they could make a single currency work without a single government.”
Lagarde, Krugman and others seem to keep coming back to the issue of fiscal unity in Europe, in a thinly veiled criticism of the way the crisis has been handled. Austerity will never work without it, and possibly even then it will fail to deliver. The IMF published an extensive research report last year in which they analysed 170 instances of fiscal austerity implemented by governments over the past 30 years; the result suggested that in all but two of the occasions, austerity failed to deliver growth. Fiscal consolidation consistently lowered incomes in the short-term and raised unemployment in the short and medium-term.
Prakash Loungani, a researcher at the IMF, explains: “Unfortunately, it is the people who are already hurting that seem to bear more of the pain from fiscal austerity. In a sense, the high street takes more of a hit then Wall Street, loosely speaking. What we find is that wage earners have a much bigger fall in their incomes than people that are dependent on profits and rents. The burden is not equally shared.”
Spain’s false hope
Germany has been spearheading the cry for austerity measures in the troubled economies of southern Europe. Initially unfalteringly supported by Sarkozy, Hollande has come in to ruin the party. David Cameron has demanded more growth stimulus from Europe, but has ploughed on through with public spending cuts at home and now Britain has plunged into a double dip recession. France is being downgraded. Hell has broken loose in all of Europe; all but Germany, whose economy has slowed down considerably but still finds itself far from recession. Indeed, it grew 0.5 percent faster than what was originally forecast in the first quarter of 2012, and the expectation is for continued growth.
According to the same IMF research it is a good idea for advanced economies to partake in some form of consolidation, which can be imperative to restore fiscal sustainability. However, if implemented too quickly, austerity measures hurt the recovery and dampen job prospects. It is now becoming clear that the austerity package designed for some European countries like Spain and Greece has vastly missed the mark.
Unemployment in Spain is the highest in the eurozone. The jobless in Spain amount to 4.65 million – 24.3 percent of the population. The situation in Greece is at least as bad and publicly enforced austerity measures are reinforcing private austerity. Wages are declining, the latest wave of cuts, totalling €1bn, has left hospitals unable to supply medication to patients, and income and property taxes skyrocketing.
The markets have not been reassured, as had been promised. Following Spain’s
recent €100bn bailout for its banks there was a glitch of optimism before European markets slumped again. Instead of relieving the pressure, the rescue money has simply added more debt to the country’s already empty pockets. Lagarde insisted in one of many June summits that the ECB helps banks directly. When suggested that Merkel might not agree, Lagarde said she hoped “wisdom would prevail.” Indeed, Soros, Krugman and many others have made similar suggestions at various points in the past few months.
It has been suggested that they key issue holding Spain back from recovery are extortionately high interest rates that prevent it from borrowing more, thus leaving the country with no alternative but to dive head-first into a pool of fiscal cuts. That might be true for Spain, which is held back by the euro, whereas other countries, when faced with the prospect of failing banks and fledging economies, have taken other routes to recovery.
Charity begins with the kroner
Iceland, for instance, allowed its banks to default in 2008. When the island’s over-leveraged banking system collapsed, the government let them do it. In the process they also devalued the economy by close to 60 percent. Unemployment soared; Icelanders fled the island by the hordes. Though the default almost bankrupted the minute nation, and forced it to borrow $10bn from the IMF, it was not the end of the little island. In fact, less than four years on the country is recovering at a rate that would make even Merkel blush. They have promptly repaid their IMF loans, including the two most recent having been made ahead of schedule.
Iceland also took the unusual step of delaying austerity measures and increasing welfare in order to guarantee continued domestic spending. “We had an economic plan that was worked out in cooperation with the IMF and basically involves running a fairly substantial budget deficit in 2009 and then gradually reducing it and returning to surplus in a couple of years,” explains Gylfi Magnússon, Minister of Business Affairs and Minister of Economic Affairs for Iceland between 2009 and 2010. “This calls for some hard decisions, but it’s not impossible.”
It was a similar strategy to the one US President Franklin Roosevelt applied during the Great Depression, when he revved up stimulus and delayed austerity measures for a few years. Iceland’s strategy of default, devalue and delay worked according to plan and the island’s economy grew 2.5 percent last year, and is set to grow the same again in 2012. By investing in the economy, not only through bailouts and quantitative easing, but through solid consumption, Iceland managed to boost sales of domestic products, and revived traditional industries like fisheries.
Iceland’s escape route was precisely the opposite to the one taken by the eurozone. When banks in Europe started to become encumbered, they were bailed out by national banks, which then some time later had to receive rescue packages from the ECB. Just as Iceland allowed its banks to default fast, Europe is extending their misery. What was originally a liquidity crisis has quickly evolved into a solvency crisis, and it won’t be long until a major European bank becomes completely insolvent altogether, triggering an unfathomable domino effect of collapsing banks and bankrupt nations.
However, Iceland is a small island with little over 330,000 inhabitants. When in 2009 the government ran a budget deficit it amassed $1.5bn. Britain released figures in March that pointed to a budget deficit of £15bn for the month of February alone, roughly 15 times that of Iceland for the entire year. When Icelandic banks defaulted, though Icelanders were spared the brunt of the crash, foreign creditors, namely British and the Nordic banks, were left to shoulder the brunt, which in turn contributed to their own banks’ problems. If banks in Europe were to default, the chain reaction of bad debt would be too catastrophic to calculate. Furthermore, the default and subsequent devaluation in Iceland acted like a form of ‘austerity in disguise’.
In 2008, €1 was worth roughly 90 Icelandic krona; that should go up to around 160 by the end of Q3 this year. Imports, invaluable to an island nation, became prohibitively expensive, so although spending was going up in terms of krona, it was drastically reduced in real terms. Iceland also has the advantage of producing around 85 percent of its energy, through powerful geo-thermal stations and other renewable sources. If Greece or Spain were to default and devalue, like Iceland, the cost of energy could potentially double or even treble. Spain imports 74 percent of its fuel; Greece well over 65 percent, and energy is only one of a plethora of essentials that Spain and Greece buy in.
Russian and Chinese independence
Default is not an option for Spain. As European banks are being forced to cut down on cross border lending, unable to borrow in the market; Spain is forced to turn to central banks, who can no longer afford to keep bailing them out. Spain is insolvent, and the recent refinancing of Banca Monte del Paschi di Siena, Italy’s (and the world’s) oldest bank, suggests that Italy is not far behind. European banks are now so exposed to Spanish debt, that to let the country or its banks default would probably bring down several other banks, and countries.
The other option is to follow in Russia’s footsteps and consistently pump money into the economy and re-structure to encourage business. In 2008, Vladimir Putin and Dmitri Medvedev reduced corporate profit tax and put in place a series of measures designed to save Russian businesses 500bn roubles a year. Medvedev also ordered several ‘injections of state funds’ into the markets, pledging ‘all necessary support’ to the financial system. Between 2008 and 2010 the fiscal stimulus package pumped into the Russian economy totalled over 13 percent of the GDP. “Russia could not devalue the rouble, because of the huge volume of foreign-currency denominated liabilities,” explain Professors Alexei Ponomarenko and Sergey Vlasov from the Institute of Economies in Transition in Finland. “In 2008 those amounted to 30 percent of the private non-financial sector share of the GDP and 19 percent of the banking sector share.”
Russia has been struggling with falling oil prices as well, since it amounts to around 40 percent of the country’s GDP. Its fiscal stimulus package had to be so large because of the necessity to compensate the significant drop in aggregate demand, both domestic and exterior, in Russian production, according to Ponomarenko and Vlasov; “it also had to increase the stability of Russian financial markets given the substantial deterioration of borrowing conditions on the international and domestic markets.”
Today, Russian GDP is almost back to its pre-crisis level, and though it is not growing as fast as it did during the pre-2008 boom, the economy is by no means struggling. A final wave of stimulus was announced as recently as last June, in which Putin ‘earmarked’ a further $40bn for use over the next two years should the situation in Europe continue to deteriorate. China, like Russia, is another example of a national proactive fiscal policy.
Though it was never at risk of going into recession, a higher-than-expected slowdown was enough to wreak havoc. When it was announced that China’s economy had only grown 9.2 percent in 2011, oil prices slumped and stock markets took a dive. This was the first indication that the troubles in the eurozone were more than just a mere minconvenience for the Chinese, and though the rate was merely 1.1 percent lower than the figures for 2010, the Chinese finance minister immediately changed gears. First came the
reassurances; fiscal deficit and debt ratios where still in the safe zone, but the Minister for Finance, Xie Xuren, was emphatic: “It is necessary and possible to continue implementing proactive policy in 2012.”
In 2008 China launched a massive stimulus programme, aimed at offsetting the worst of the economic downturn. The package, estimated at around $570bn, was invested in 10 key areas including affordable housing, rural infrastructure, energy, water, transportation and technological innovation. Due to this stimulus, China staved off the worst of the crisis, and though it has consistently continued to invest in the economy, the growth forecast for 2012 is only 7.5 percent, the lowest in twenty years. “China has to rely on infrastructure investment to manage economic slowdown,” says Zhang Hanya, the head of China’s investment association.
The problem China faces right now is a consequence of the illfate European consumers have endured over the past four years. Household consumption in China is a mere 35 percent of the GDP, about half the level of the US. Most of what is produced in China is consumed by Europe and the US, as fiscal austerity bites into consumers’ pockets; Chinese manufacturers have felt the brunt. And it is likely to continue spreading.
The asperity of austerity
The common misconception currently appearing centre-stage in the coverage of the crisis is that it was caused by rampant borrowing in the public sphere, and that might be true for Greece. It is not, however, true for anywhere else; the root cause behind the current crisis was irresponsible borrowing and lending by the private sector, especially over leveraged banks. According to the Manifesto for Economic Sense by Richard Layard and Krugman, “the bursting of this bubble led to large falls in output and thus in tax revenue. Today’s government deficits are a consequence of the crisis, not a cause.”
At first governments in Europe turned to fiscal stimulus, but that strategy was quickly abandoned in favour of spending cuts and further austerity measures. The quickest and most logical way out of a bad situation would have been for fiscal policy to act as stabiliser, sustaining spending while the private sector got back on its feet. What is happening is exactly the opposite, as the public sector tries to reduce its debt on par with the private sector and no one is spending. As the crisis bites, the ties of the eurozone, which were meant to strengthen economies, become chains that restrain rather than protect.
Unemployment is soaring across Europe and periphery countries are not competitive.
More austerity is on its way. Nouriel Roubini believes that the “painful deleveraging – spending less and saving more to reduce debts – is depressing domestic private and public demand and the only hope of restoring growth is an improvement in the trade balance, which requires a much weaker euro”. But even that will not change the fact that there is competition within the euro, and at the moment, Spain, Portugal and Italy, whose labour costs have gone up between 30 and 40 percent over the last decade, will never be able to compete with Germany, whose labour costs increase much more slowly than the rest of Europe. The euro system is indeed flawed.
The crisis has highlighted how a monetary union without fiscal or banking unions leaves each country exposed to ups and downs in neighbouring economies. Krugman compares Greece to the US state of Florida, both members of monetary unions, though as he points out, only Florida belongs to a fiscal and banking union: “In the aftermath of its huge housing bubble, if the state had to come up with the money for Social Security and Medicare out of its own suddenly reduced revenues. Luckily for Florida, Washington rather than Tallahassee is picking up the tab.”
Meanwhile, European banks are still reluctant to offer loans and mortgages, and the economy overall is not moving as fast as what might have been expected. In early July the ECB announced yet another cut to its base interest rates, bringing it down by 0.21 percent in a small but significant measure to stimulate lending. China, fretful after its economy slowed down more than expected, reduced its base interest rates by 0.31 percent to six percent per year in an attempt to avoid a further slide in manufacturing, preventing a possible collapse of property values. The UK has approved another £50bn in quantitative easing to try and step out of its recession. Of course, as interest rates are held artificially low, depositors are feeling the pinch in their savings. With banks slow on the lending, borrowers aren’t benefiting much either.
The unbeatable debt anvil
There have been calls for a structural reform of the eurozone for months, and a number of talks have collapsed when Germany refused point blank to consider the idea of a banking and fiscal union that would help Europe deal with crisis situations. But in a summit at the end of June, the leaders of the 17 euro nations agreed to a radical restructuring of the EU lending mechanisms. Merkel had previously refused outright to accept any reform that would allow the ECB to bail out any bank directly over concerns of repayment. But in an all-night meeting in Brussels, she was forced to yield.
During the last such summit in 2011, European leaders failed to devise even a basic plan of action for the next institutional steps. But during this summit an acceptable compromise has been achieved. Word on the EU street is that Mario Monti, Italy’s Prime Minister, forced it out of Merkel to agree on a deal. But this is just the first small step towards an achievable solution. “The eurozone’s future is now stuck inside the world’s smallest and tightest suitcase,” says François Godement, Professor of Political Science at Science Po in Paris. “Namely, the solution to the crisis is dependent on a banking union, which is in itself still conditional on a banking supervision authority, which remains to be created.”
The creation of a centralised supervisory authority is certainly a good move; at the moment there are such myriad institutions that operate on national and cross border levels. Another key aspect of the deal is that some of Spain’s already approved €100bn bailout will be funnelled by the ECB directly into the banks, therefore avoiding an unnecessary increase in sovereign debt for the benefit of local banks. This was a huge step for Germany, “it is conditioning its new support to a pledge for common supervising authority, although it would have preferred implementing the supervision before loosening the strings of the purse,” says Godement.
This is just one step, and the EU has recently been moving one step forward and two steps back. Since the end of 2011, ECB President Mario Draghi has reduced policy rates and injected over €1trn in liquidity into the banking system at the same time as Greece, avoiding a default through a stringent restructuring of public debt. One step forward. But the insistence in ravaging austerity measures have pushed Spain and Italy further toward the precipice, allowing the crisis to start backtracking from the periphery to the heart of the EU. So that’s three steps back.