Austerity - What Should Have Been Learned
The IMF should have known that austerity policies (reduce government deficits) cause unemployment to grow. After all, its own research found that a reduction in the government deficit of 1% in GDP results in an increase of .3 percentage points in the unemployment rate.
But it got roped into pushing austerity in both Greece and Spain by the Germans. So what happened? Table 1 provides the IMF's GDP growth rate projections made in both 2010 and 2012. Back in 2010, the Fund estimated growth rates of 0.2% and 1.5% for Greece and Spain, respectively for 2012. The IMF now projects GDP to decline this year by 4.7% in Greece and by 1.8% in Spain.
Table 1. - IMF Growth Rate Estimates, Made in 2010 and 2012
Year of Est.
Source: IMF (WEO Database and Country Reports)
It also appears the IMF missed the effect of austerity on unemployment. Back in 2010, the Fund thought unemployment in Spain would be 18% this year - bad enough. In fact, unemployment is over 24% with more than 50% of younger people out of work. The situation is similar in Greece - in 2010 the Fund estimated 2012 unemployment at 15% where it is in fact at 22%. Well, the Fund learned its lesson. What has happened to Greece and Spain in the last two years convinced the IMF and many others that more austerity will not work.
So now, the new "buzz" word is "growth". All Eurozone leaders are talking about it. I have two questions:
- What now is being said about government deficits, the target of the austerity hawks?
- How exactly is growth to be promoted?
Keynes and economists that followed him believed that at a time the private sector is not providing enough jobs (Greece and Spain today), the government must step in to get people back to work. Governments can do this either by cutting taxes (leaving citizens with more income to spend) or by increasing expenditures. In either case, government deficits will increase. So what is the IMF saying now, and how does it compare with what it was saying a few years back in the "austerity era"?
To get an answer to this question, I compared IMF statements in the recent Concluding Statement of its 2012 Article IV Consultation with Spain with what it said in 2010. In 2010, it said:
"Spain has started ambitious fiscal consolidation to reach the 3 percent of GDP deficit target by 2013. This new package significantly strengthened the envisaged adjustment and enhanced credibility by taking concrete and emblematic measures.…The new deficit path is also appropriately front-loaded, with nearly two-thirds of the required adjustment achieved by 2011."
So that was the plan in 2010. But that is not how things turned out. The 2011 deficit turned out to be closer to 9% than 6%. The Fund was clearly not happy. I quote from the "Concluding Statement":
"The impact of the large overrun (almost 3 percent of GDP) was exacerbated by maintaining the message, until almost the end of the year, that the deficit was on track, and by the lack of timely and reliable data."
Looking ahead, the IMF says: "…the very ambitious 5.3 percent of GDP deficit target for 2012 will likely be missed.
So as the Fund and its partners move from "Austerity" to "Growth", how are the statements on government deficits changing? The following are quotes from the IMF:
- Because structural reforms will take time to generate growth, aggregate demand support is needed in the short run.
- Fiscal consolidation should proceed decisively and credibly where market pressure is high, but more gradually elsewhere to help support demand in the region….In this context, the flexible implementation of the current fiscal framework is essential.
- Growth projections are in line with ours, but incorporating the fiscal consolidation envisaged in the Stability Program would entail lower growth under staff's framework.
- Given the weak growth outlook, however, slippage should not be made up in a compressed timeframe.
- The deficit path envisaged in the Stability Program should be less front-loaded (in agreement with European partners).
I quote further from a paper written by Nemat Shafik, a senior official in the Fund
"We all know that fiscal consolidation―reducing deficits by cutting spending or raising revenues―can stifle growth. When a number of countries need to engage in fiscal consolidation simultaneously, the negative impact on growth is reinforced. Getting the pace of fiscal consolidation right is therefore of paramount importance, especially given the current context of weak growth and employment…. Overall, fiscal adjustment plans for this year are broadly appropriate in Europe. In a few euro area countries, however, the nominal fiscal targets for 2013 agreed before the current slowdown in growth may prove too pro-cyclical and may need to be adjusted or at least expressed in structural terms. The Stability and Growth Pact's excessive deficit procedure does allow for some flexibility in deciding how fast to bring deficits below 3 percent of GDP. Should economic conditions worsen, this flexibility should be used to revise deadlines for meeting the targets."
The quotes make it clear the Fund has learned its lesson on austerity. It is saying as clearly as it says anything: ease up on government deficit reductions - they will reduce growth and make things worse. Germany is now pretty much by itself in still pushing austerity for Greece and Spain.
Growth - How Is It To Be Achieved?
So the Fund has backed away from austerity as the solution in Greece and Spain. Growth is now in. How will it be achieved? To answer this question, I again quote from the 2012 statement referenced above. While this document applies to Spain, the IMF is saying exactly the same thing to Greece.
- To restore growth across the union, long-standing structural rigidities need to be tackled to raise long-term growth prospects. In many countries, labor market reforms are needed to raise participation and address disparities in protection that confine "outsiders" (typically younger workers) to low-wage, temporary jobs….
- …targeted investment in infrastructure and human capital will support growth and employment.
- Lowering unit labor costs in the tradables sector is essential for deficit countries. This means productivity-enhancing reforms (e.g., lowering barriers to entry, making it easier for small firms to expand into foreign markets) and labor market measures that ensure that nominal wage developments are aligned with productivity growth.
- To foster relative price adjustment between the North and the South, monetary policy should ensure that overall inflation does not drop far below the two percent for the euro area as a whole, while allowing for larger inflation differentials between North and South.
- Unfortunately, there is no magic bullet to spur growth and job creation. Crisis-hit countries in Europe will only be able to revitalize their economies by selling more goods abroad and creating new jobs in the private sector.
- This challenge is complicated by the constraints imposed by the Eurozone. In a context where the exchange rate cannot be devalued and productivity increases only take hold over time, improving competitiveness unfortunately requires a reduction in costs, including labor costs.
So what, in essence is the Fund saying? What is its formula for growth?
- Growth will require Greece and Spain to become competitive with Germany.
- This cannot happen via an adjustment in the exchange rate because all Eurozone countries use the Euro.
- How can it be accomplished? Greek and Spanish workers will have to become more productive.
- That means cutting jobs and reducing wages.
- Eurozone monetary policy should be inflationary. This will cause prices to increase in the full employment countries. Prices will not increase in Greece and Spain and that differential will improve their competitive position.
There is nothing promising in what the IMF saying in moving from Austerity to Growth. Growth apparently means Greece and Spain must get their costs down so they can compete with Germany. How to get there? Greece and Spain must cut jobs and wages. This is not going to happen, and without currencies they can devalue to make the adjustment, the Greece and Spain are locked into a system in which they cannot compete. This is not a sustainable situation.
And while one side of the IMF is calling for this "technological fix" that will not work the political side of the IMF is calling for more Eurozone backing to avoid "contagion".
Is there a legitimate reason for a contagion concern? In an earlier piece, I calculated Foreign Claim/Other Potential Exposures of banks in major countries to banking collapses in Greece, Italy, Portugal and Spain. The results are presented in Table 2. The percent of total deposits is worrisome as are the sizeable amounts.
Table 2. - Foreign Bank Exposures
Another contagion concern - possible bank runs in Greece, Italy, Portugal and Spain. According to the European Central Bank, total banks deposits in these four countries are $6.3 trillion. They should be insured.
Investing in these troubled times? I will stick with 4-5% yields I can get on emerging market debt (ELD, TGEIX) and US real estate (MUTF:FRIFX).
Disclosure: I am long ELD.