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Europe's rush to impose austerity measures could prove disastrous

Austerity measures | Europe's rush to impose austerity measures could prove disastrous Ian Fraser

Call it the new frugality but deficit reduction has become economic flavour of the month across most of Europe.

The turning point came  at the recent meeting of G20 finance ministers and central bank governors in Korea, in early June.

Fortune magazine said those present had a collective crise de coeur after becoming "alarmed by the public finances of some countries".

Together they "made clear that they could no longer wait until economies pick up steam before removing fiscal stimulus." The US faith in Keynesianism, including the core belief that stimulus must be maintained until recovery is assured, has proved more resilient.

What today's frugalists don't seem to realise, however, is that austerity is no panacea. It is therefore reassuring that the frugalists have come under attack from various quarters in recent weeks.

The New York Times economics blogger and columnist Paul Krugman has been leading the charge. He recently characterized European politicians' penchant for austerity measures as “crazy”. He believes they may anyway have misinterpreted what the markets want, warning they risk leading their countries into a Japanese-style economic cul-de-sac. In a partly satirical blog Krugman wrote:

The key thing you need to realize is that eliminating stimulus spending, while it would inflict severe economic harm, would do almost nothing to reduce future debt problems ....

So wise policy, as defined by the G20, consists of destroying economic recovery in order to satisfy hypothetical irrational demands from the markets — demands that economies suffer pointless pain to show their determination, demands that markets aren’t actually making, but which serious people, in their wisdom, believe that the markets will make one of these days.

I recently interviewed Bruce Stout, the Aberdeen Asset Management fund manager who runs the top-performing Murray International investment trust, and author of a forthcoming Viewpoint article, on this very phenomenon.

Stout agrees that austerity is no panacea for a troubled economy. One negative is that, as a government slashes its public sector, the overall tax take also falls (after all, unemployed public servants don't pay any income or employment taxes). Stout believes many economists have been skirting around this inconvenient truth.

There's a whole generation of economists in the US and UK are only familiar with one scenario, the “the credit cycle”.

In such a cycle, says Stout, policymakers became the equivalent of 'one-club golfers'. Their response to overheating economy is to ramp up interest rates. Their response to a crisis or slowdown is slash rates and hope for the best.

“But we cannot do it this time, because the deteriorating primary and structural deficits are making that more difficult. Interest rates have been cut to 0.5% to 1% but nothing has has happened. You take the horse to the water trough but you cannot make it drink. The credit has been crowded out by debt servicing. So now you realize, cutting interest rates didn’t work. What else can we try?"

He said economists’ and policymakers' response has been to assume that savage government spending cuts will resolve the problem. But, he said, they are ignoring the revenue side of the national balance sheet.

Crudely, Britain has £500bn in revenues on one side, and £680bn in expenditures on the other. So the simplistic minister says, let us just cut away the £180bn difference and it all balances out. What they don’t understand as you cut into the £680bn, the £500bn contracts at the same time!”

The fact austerity measures are unlikely even to placate the markets is evidenced by Krugman. In his most recent blog post, he wrote: "Markets continue to treat Ireland, which has accepted savage austerity with little resistance, as being somewhat riskier than Spain, which has accepted austerity slowly and reluctantly."

Further reading on Europe's austerity measures

Tags: central banks , deficit reduction , EU , fiscal stimulus , GDP growth , sovereign debt
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  1. Anonymous Comment says:
    Wed Jun 20 14:49:09 BST 2012

    Call it the new frugality but deficit reduction has become economic flavour of the month across most of Europe.
  2. Ian Fraser says:
    Thu Jun 17 09:27:29 BST 2010

    Writing in National Review Online Stephen Spruiell has taken issue with Krugman's use of a comparison between Ireland and Spain to prove his theory that austerity does not reassure the markets. Here's the link:

    In his piece Spruiell accuses Krugman of using data selectively and ignoring the comparative indebtedness of Spain and Ireland.

    "Amazingly, Krugman ignored the question that comes so readily to mind: Is there anything else that might account for the difference? ... there is: Ireland is more indebted than Spain, and has the highest budget deficit of any of the troubled PIIGS (Portugal, Ireland, Italy, Greece, Spain). Portugal, like Spain, has an iffy austerity plan, but it also has a larger debt load (86 percent) than Ireland (77 percent) or Spain (65 percent). As one might expect, its CDS spreads are not just wider, but disproportionately wider..."

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