Austerity Isn't Working; It's Time for a Plan B
Associate Editor, CNBC
Ever since the financial crisis of 2008 it feels as if markets are never that far away from another bad news story.
Take the last month for instance. Japan fell back into recession as did Australia. Greece looks like it will need a second bailout or a “re-profiling” or restructuring of its debt – with both terms sounding suspiciously like the other.
The Portuguese Socialists lost the election, the Spanish government suffered losses in local elections because of drastic spending cuts aimed at keeping it from going to the IMF for help. So did the German government despite the German economy being by far and away the healthiest of the European economies.
The Organisation for Economic Cooperation and Development (OECD) lowered its gross domestic product growth forecast for the United Kingdom, while Moody’s rating agency put 14 British banks on warning that they faced a downgrade in their credit ratings.
The United States was warned of a negative outlook on its economy and possible downgrade of its credit rating by Standard & Poor’s and failed to reach agreement over raising the Federal debt ceiling having barely managed to reach agreement over the Federal budget.
And yet - despite the threat of bankruptcy in August if no agreement is reached with Congress - 10-year US bond yields fell to historic lows as investors sought safety from the volatility elsewhere.
While the US has pursued a policy of easy money and low interest rates, much of Europe has over the last twelve months adopted fiscal austerity measures, cutting public spending in an effort to deal with deficits and in order to convince the bond markets their economies are on a stable footing.
However, such austerity measures have had mixed results.
In Germany three quarters of negative growth in 2008 during the financial crisis have been followed by positive growth ever since, with GDP in the first quarter of 2011 standing at 1.5 percent. This has been in spite of spending cuts of 80 billion euros ($116.8 billion) introduced in June 2010 by which time the German economy had seen four quarters of positive growth already.
In Portugal, the reverse has been true. In November 2010 Portugal voted through an austerity package that aimed to cut the budget deficit from 9.3 percent to 7.3 percent by the end of the year and to reduce it to 4.6 percent by the end of 2011.
But GDP in Portugal fell by 0.7 percent in the first quarter of 2011, having fallen by 0.3 percent the previous quarter, after recovering at the start of 2010 - before austerity measures were introduced - from the previous year’s recession in which the economy declined by 1.7 percent overall.
Meanwhile, in the UK, having appeared to have dug its way out of the worst recession the country had experience since the Great Depression - and a total decline in GDP of 9 percent between the third quarter of 2007 and the second quarter of 2009 according to the Office of National Statistics - growth appeared to stall at the end of 2010.
The economy shrank by 0.5 percent in the final quarter of the year only to recover 0.5 percent in the first quarter of 2011 effectively meaning it stood still and there have been growing calls for policy makers to consider a plan B even though the government’s spending cuts have yet to fully take hold.
Marauding Groups of Economists
Over the weekend a battle between marauding groups of economists raged in the newspapers as one group called for the government to consider a Plan B in an open letter in Sunday's Observer newspaper, while in Monday's City AM the Adam Smith Institute sought to discredit their views, claiming only a handful were actually practicing economistswhile the rest were retired.
The group of 50 academics and economists called on the government to draw up plans to ease the pace of its austerity programme arguing the economy is too fragile to cope with the pace of the change.
Recent economic figures had shown that the government urgently needed to adopt a Plan B for the economy, the group of economists said in the letter.
“As economists and academics, we know the breakneck deficit-reduction plan, based largely on spending cuts, is self-defeating even on its own terms”, they wrote.
“It will probably not manage to close the deficit in the planned time frame and the government's strategy is likely to result in a lot more pain and a lot less gain,” the letter added.
The group called for a green “new deal” and a focus on targeted industrial policy, a clamp down on tax avoidance and evasion, as well as raising taxes on those best able to pay and real financial reform and job creation, "un-squeezing" the incomes of the majority, empowering workers and the promotion of a better work-life balance.
“These are the foundations of a real alternative and it is time the government adopted it,” the group added.
Vicky Pryce, senior managing director at FTI and a former government adviser was one of the signatories to the letter to the Observer. She told CNBC.com the government had to be more flexible in its approach to the economy.
“There has to be more flexibility in how we move from here to what the government’s plans are to reduce the deficit by the end of that period. There will be years where we are not growing very fast like now and we should allow the automatic stabilizers to work but also say something along those lines so that people realize that you are not going to just suddenly do something additional,” she said.
“Inevitably the tax take goes down and your welfare benefits go up which mean s that in that year you may not be doing as well as you otherwise would. So the point for me is more flexibility but make sure that people realize that you are flexible so that confidence doesn’t suddenly get upset because people begin to think that you are going to be instituting even more cuts.”
In response Chancellor George Osborne told the BBC Radio's Today programme that the UK's fiscal plan was "credible".
"The economy is growing, jobs are being created. We would like the economy to grow further and we would like more jobs to be created," he said.
He described the fiscal plan as "the rock on which the British economy rests at the moment" and although he did not talk about the government having a plan B he said: "We have flexibility built into our plan."
Protests Against Austerity
Meanwhile, in Greece there were large protests against further austerity cuts in the country on Sunday, while national elections in Portugal saw a 10 percent swing to the right making the center right Social Democratic party the largest political force in the country effectively showing national support for more austerity plans.
Peter Dixon, economist at Commerzbank told CNBC.com the problem for most governments and observers is that the full effects of the spending cuts are still unknown and largely unknowable.
“In the absence of any evidence, just because plan A has not really taken effect, it’s a bit early to talk about a plan B," Dixon said.
"No one has really put in place a sustained programme of cuts in public spending for any real length of time. We are starting to see the impact of these spending cuts now but its still too early to be sure of their impact," he added.
Each country has implemented spending cuts at different times in their economic cycle, while some have had no choice but to implement spending cuts in order to receive help – Greece, Ireland and Portugal.
However, George Buckley, economist at Deutsche Bank suggested to CNBC.com there were very few Western economies that had a genuine choice about spending cuts.
Greece, for example, clearly had no choice but to implement spending cuts in order to get help from the IMF, he argued.
No Money for Nothing
“It had to be part of the answer for Greece. The EU would not accept and will not accept Greece being given money without some form of fiscal tightening,” Buckley said.
“Greece’s GDP is contracting by 6 percent per year. It is very difficult to achieve fiscal austerity under those conditions but it’s very difficult to do anything else when you are facing debt of 150 percent of GDP,” he added.
Such economists take the view that other Western economies equally have had no choice.
Looking at the UK, Buckley argued if the coalition government had not set in motion the spending cuts they have in the last two months Britain could have faced a downgrade of its own credit rating and a bond selloff.
This, he said, was still a real threat despite little evidence from bond yields, either last year or now, to suggest investors were particularly worried about the UK’s ability to deal with its debt.
"The question is where UK yields would have been if we had done nothing. Yields could well have been 50 basis points higher than they are today and there was a real risk of a downgrade from the ratings agencies. Rates are now lower than they would have been if we have done nothing,” he told CNBC.com.
“If we look at the structural deficit in March 2010 and look at the changes in the structural deficit in March 2011 there is little difference between the two. The cuts the UK government is making are equivalent to two percent of GDP over the next couple of years on average,” Buckley added.
Dixon however is on the opposite side of the argument telling CNBC.com it was impossible to impose fiscal austerity in order “grow your way out of a fiscal debt crisis.”
Economy 'Flat on Its Back'
“It is a misconception that if you cut government spending the private sector is going to rush in to fill the gap left behind. I have never seen that work in reality. It only works in the minds of some economists’ theoretical hypotheses. Given the economy is flat on its back you are making the problem worse because you are reducing you ability to raise tax receipts and reducing economic growth,” he said.
If Greece, Dixon argued, had it done a better job of collecting the taxes it was owed by its citizens in the first place it may have avoided a bail out altogether. Although he agreed increasing public spending was simply no longer an option for Greece, Portugal or Ireland.
In terms of the US however, there are increasing concerns about fiscal policy.
While the US has been one of the few countries to spend its way out of recession - some such as Britain’s prime minister David Cameron would argue one of the few countries still able to do so due to its reserve currency status and the fact that it remains the largest economy in the world - concerns are beginning to grow about how much longer it will be able to pursue such policies.
“In the US Obama feels it’s not wise to tighten before the election which is probably sensible given the weakness of the economic recovery. It’s deemed not to be the right time to go there,” said Dixon.
“But if you look 10 years into the future it points to a very sharp rise in debt levels for the US, which raises the question of whether the US can still find buyers for its debt in the future, which is pretty big question,” he added.
Too Deep in Debt to Spend
While Keynesian economics had not been discredited, Western economies had become too indebted over the last decade to be able to pursue the sort of policies that in the past would have allowed them to spend their way out of a recession, Buckley said.
“When you get high levels of debt you get lower economic growth. No county wants to have their debt level going up over 100 percent of GDP. No country wants to be in debt to another country in the way Ireland, Portugal and Greece are. I don’t think Keynesian economics is discredited but at some point you have to pay back what you owe. You can’t continue spending forever,” he said.
However Obama, and others such as former British prime minister Gordon Brown, has consistently argued the issue remains not whether to cut spending but the pace and timing of cuts.
According to Dixon, the error that policy markers may be making is to assume their economy has recovered enough for them to remove fiscal stimulus measures earlier than they should.
“Every one knows there needs to be fiscal reduction but there’s still an open debate across the industrial world over the timing. If it proves to have been too quick then we will have more stagflation, higher unemployment and an even more unhappy electorate," he said.
“Many electorates are not happy with the way their governments are running their economies already and those governments can’t afford that,” he added.
At the same time considering plan B, as has been suggested in some quarters including Obama on his visit to Britain last month, doesn’t at this stage appear to be an option.
“Part of the reason behind fiscal tightening is to convince the markets. You don’t want to tell the markets you have a plan B. What you do is not follow through with pan A [if it is not working] quite as fully as you said you were going to do,” said Dixon.
CORRECTION: CNBC wrongly reported that Jonathon Portes was among 52 economists that wrote a letter to the Observer newspaper last week calling on the coalition government to consider a Plan B on economic growth and public spending cuts. While Portes was quoted in the Observer newspaper, he was not a signatory to the letter.