Think Again

Think Again: Austerity

The big spenders are wrong: Maintaining sustainable budgets is essential to economic growth.

In the current global financial crisis, austerity has become a term of abuse -- one that connotes unnecessary pain and suffering on the part of already-hurting citizens. But that couldn't be further from the truth. What austerity actually means is "measures to reduce a budget deficit" or responsible fiscal policy. And that's hardly the only misconception that has clouded our economic thinking of late.

Although you'd never know it, the so-called global financial crisis is really a public debt crisis -- and the countries that have reigned in their spending are now growing briskly while the profligate founder. Here are five other myths about austerity that have muddied the waters.

"Growth Requires Fiscal Stimulus."

Wrong. In fact, the opposite is true. Sustainable long-term economic growth requires sound public finances as well as capital, labor, human capital, technology, and strong institutions. British economist John Maynard Keynes, the original proponent of stimulus spending, argued in The General Theory of Employment, Interest and Money that classical economic theory is "applicable to a special case only" and "that the duty of ordering the current volume of investment cannot safely be left in private hands." But stagflation in the 1970s taught us that the relevance of Keynesianism was limited to brief periods of recession. Even Keynes envisaged that budgets should be balanced over the course of the business cycle.

For a fiscal stimulus to be permissible there must be what economists call "fiscal space" for it. In other words, the public debt accrued through stimulus spending must be sustainable. The trouble is, fiscal space is difficult to establish, and it's typically much smaller than we think. During a severe financial crisis, moreover, public debt usually doubles, meaning that there is virtually no fiscal maneuverability. By the end of 2011, for example, eurozone public debt averaged fully 98 percent of GDP, and by the end of 2012, the six biggest Western economies had the following debt-to-GDP ratios: 83 percent in Germany, 89 percent in Britain, 90 percent in France, 107 percent in the United States, 126 percent in Italy, and 237 percent in Japan. None of these countries has any fiscal space.

Given this reality, the main objective of fiscal policy should be to contain public debt, all the more so because of its negative impact on growth. According to economists at the University of Massachusetts, GDP growth falls substantially -- and predictably -- with rising public debt. When a country's debt-to-GDP ratio sits between 60 and 90 percent, they note, average annual real GDP growth is close to 3.2 percent. Where the debt-to-GDP ratio falls in the 90 to 120 percent range, average real GDP growth is 2.4 percent. And when the ratio is between 120 and 150 percent, average growth is a sluggish 1.6 percent.

But it's not just public debt that needs to be taken into account when considering fiscal stimulus -- access to international financing is also critical. Small countries with illiquid bond markets can lose such access at minimal levels of indebtedness, as Latvia and Romania did in 2008, when their ratios of gross public debt to GDP were just 20 and 13 percent, respectively. Despite this cautionary tale, however, the IMF in 2008 and 2009 urged Cyprus, Slovenia, and Spain to pursue fiscal stimulus, wrongly claiming they had fiscal space. That unfortunate advice contributed to pushing all three countries into financial jeopardy. So far, nine out of 27 EU member countries have faced sharp output falls and financial stabilization programs because of irresponsible fiscal policy.

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"OK, Stimulus Isn't Always a Good Idea, but It's Necessary When a Country Has a Large Output Gap."

False. Fiscal stimulus is rarely beneficial. Before the global financial crisis, there was broad macroeconomic consensus that fiscal policy was not an appropriate tool for moderating the business cycle. It's slow, imprecise, and difficult to reverse. Monetary policy, by contrast, can be decided, implemented, and withdrawn instantly and is thus a far superior vehicle for countercyclical policy.

But in the midst of the financial crisis, desperate G-20 leaders threw these well-established insights overboard and embraced old-style Keynesianism once again. At the November 2008 G-20 summit in Washington, leaders declared their intention to "use fiscal measures to stimulate domestic demand to rapid effect, as appropriate, while maintaining a policy framework conducive to fiscal sustainability." It would have been better if they had stuck to monetary measures.

Fiscal stimulus requires parliamentary authorization, which takes time and usually involves complex compromises. Typical projects, such as infrastructure investments, take years to implement, easily turning procyclical. In this way, temporary fiscal stimulus tends to become permanent, leading to chronic budget deficits. Cyprus and Slovenia offer excellent illustrations. In 2008, both countries had relatively small public debt loads (22 and 49 percent of GDP, respectively). In 2009, however, both expanded their budget deficits to 6 percent of GDP, where they got stuck, eventually ending up in financial crisis.

In theory, an output gap represents free capacity, but in periods of severe overheating, like in 2007, economies are operating far beyond their capacities. According to the European Commission, for example, Latvian GDP in 2007 was as much as 14 percent above actual capacity. In such cases, what looks like an output gap is actually nothing but the usage of borrowed resources. It is also difficult to assess whether free capacity is of real economic value until years later. Often, an apparent cyclical problem turns out to be structural. In the 1970s, for example, Western Europe considered its steelworks and shipyards in cyclical crises until it became apparent that they were chronically underperforming and had to be closed down. "Output gaps" that have lasted for five or more years are probably chimeras.

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"Austerity Harms Economic Growth."

Not so. In the current financial crisis, Northern Europe has minimized fiscal stimulus and grown reasonably well, while Southern Europe, France, and Britain have pursued fiscal stimulus and all suffered from recession.

Sweden and Britain offer the starkest contrasts. Sweden maintained a steady budget surplus during the good years from 2004 to 2008. In 2009, it let the budget balance slip by 3 percent of GDP, but it returned to budget surplus in 2010. Britain, by contrast, wasted the good years with budget deficits of around 3 percent of GDP and lurched to a massive 11.5 percent budget deficit in 2009, when it rolled out the largest stimulus package in the European Union. The result? Austere Sweden enjoyed 6 percent more growth than free-spending Britain from 2009 to 2011.

Remarkably, British financial journalist Martin Wolf has written one article after another in the Financial Times complaining about alleged British "austerity," ignoring the fact that his country has maintained the largest public deficit (9.3 percent of GDP) from 2009 to 2012 of any EU country apart from Greece, Ireland, and Spain. Until it gets its public finances in order, Britain will have trouble restoring investors' confidence.

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"Even if Austerity Works, It Should Be Delayed as Long as Possible."

Not if you want to kick-start growth as soon as possible. At the annual IMF meeting in Tokyo last October, the fund's managing director, Christine Lagarde, told crisis countries to abstain from front-loading spending cuts and tax increases: "It's sometimes better to have a bit more time," she said, singling out Portugal, Spain, and Greece for slower fiscal adjustment. Lagarde's advice was based on an IMF working paper claiming that fiscal multipliers are greater in the short term than previously thought. But the paper was based on dubious forecasts of growth and considered only the ensuing year, disregarding other factors like access to capital markets.

Contrary to the IMF's position, countries in serious financial crisis have plenty of reasons to front-load stabilization programs. For example, many countries hit their borrowing ceilings suddenly and unexpectedly because of the inherent volatility of credit markets. The earlier sufficient fiscal adjustment is undertaken, the earlier confidence can be restored among citizens, businesses, governments, and foreign investors.

Early crisis resolution also breeds better reform programs that rely more heavily on expenditure cuts than tax hikes, since the latter are difficult to swallow during an economic crisis. Large expenditure cuts drive structural reforms, which in turn promote growth. Rapid crisis resolution, moreover, means a faster return to growth and, thanks to structural reforms, a higher trajectory of growth than would have otherwise been the case.

Early and radical adjustment may also be preferable from a political standpoint because people are prepared to make sacrifices when a crisis hits -- not many months (or years) after the fact, when they are tired and interest groups have had a chance to regroup. This April, Lagarde called "fatigue of both governments and population" the greatest risk to the eurozone: "What we're saying," she said, "is 'There's a bit more to do. Please don't give up now.'" But why did she tell them to slow down half a year earlier?

The empirical record is stunningly clear. The three Baltic countries -- Estonia, Latvia, and Lithuania -- suffered the most from the international liquidity freeze in the fall of 2008. All subsequently undertook front-loaded fiscal adjustment programs. By 2011 and 2012, they were Europe's fastest-growth countries, averaging around 5 percent growth annually. The Southern European crisis countries, by contrast, followed the IMF's advice to delay fiscal tightening. They have tried to raise more revenues instead of cutting expenditures and have carried out far milder structural reforms. As a result, their economies continue to suffer, and their populations are rightly upset over their governments' impotent response to the crisis.


"Greece Is a Victim of German Austerity."

Paul Krugman wants you to think that. But it couldn't be further from the truth. In one of his many New York Times columns on the current eurocrisis, Krugman argues that while there are "big failings" in Greece's economy, politics, and society, "those failings aren't what caused the crisis that is tearing Greece apart." Instead, the Princeton University economist blames the euro and Germany: Greece "is mainly in trouble thanks to the arrogance of European officials," he writes.

If the EU is guilty of arrogance, its sin was one of omission -- not imposing its standards. From 1990 until 2008, Greece ran an average budget deficit of over 7 percent of GDP, failing to comply with the EU's budget ceiling of 3 percent of GDP in any single year. By the end of 2011, its public debt stood at an unsustainable 171 percent of GDP.

The first IMF-EU financial support program, moreover, was probably the softest and most heavily-financed program in history. Incredibly, Greece's public expenditures as a share of GDP increased marginally to 51.8 percent of GDP the following year. Not even Sweden made such large public expenditures. Far from austerity, the program amounted to a massive waste of public resources.

Shockingly, the IMF and the EU have failed to require even elementary liberalization. Greece has the worst business environment in the EU, according to the World Bank's "Ease of Doing Business" index, and Transparency International reports that its corruption is far worse than that of Bulgaria and Romania. The problem isn't that Germany and the EU have been too tough with Greece; it's that they've been too soft.

The second death of Keynesianism is long overdue. Expansionary fiscal policy has not only proved useless, but harmful in the European financial crisis. As former U.S. Treasury Secretary Lawrence Summers pointed out this month, "It is simply wrong to assert that austerity is never the right policy."


Think Again

Think Again: Margaret Thatcher

The former British prime minister was a transformative politician. But her public image as an unblinking Iron Lady fails to do justice to her complexity.

As a trip to any London newsstand this week will tell you, Margaret Thatcher's political mission was an inherently polarizing one. To her fans she remains the very embodiment of self-assured conservatism, the woman who unapologetically celebrated the values of patriotism and free enterprise. To her foes she remains Thatcher the Milk Snatcher, the sneering prima donna who slashed away at the British welfare state, spared little time for the poor, and opened the way to an era of excess and greed.

Both of these images are caricatures. Yes, the late Thatcher was a leader of extraordinary single-mindedness -- she had to be, given her status as a woman who aimed to have her way in the overwhelmingly male world of British postwar politics. She won election as British prime minister in 1979 and held onto the office for 11 years -- longer than any of her democratic counterparts during the twentieth century. Her calculated flintiness cemented her popular image as the "Iron Lady" (a nickname originally bestowed her by a Soviet newspaper that was attempting to mock her, but which she characteristically embraced instead). In reality, however, she was also a practical political operator with a sharp sense of the limits imposed by public opinion. Indeed, not all of her policies were as radical as her myth suggests. Here are a few misconceptions:

"She Hated Big Government."

Up to a point. One of Thatcher's signature achievements was her privatization program, which took some of the key industries that had been nationalized by the Labour Party in 1945 and restored them to private ownership. British Gas, the telephone company, and industrial firms were removed from state control, their shares sold off to investors. The idea was to get government out of the direct day-to-day management of companies that were better off exposed to the bracing discipline of the markets. A similar logic motivated her policy of selling off hundreds of thousands of public housing units to the people who lived in them -- transforming them from tenants to homeowners. Bureaucratic regulation of any kind of economic activity was a red flag to her, and she slashed away at red tape wherever she found it. One of her most important moves after becaming prime minister in 1979 was the abolition of exchange controls, an important precondition for the later "Big Bang" (her late 1980s deregulation push that almost instantly transformed London into a major European financial center.)

All of this was dramatic enough, and certainly reduced the extent to which the government intervened in the lives of ordinary people. And yet she pointedly shied away from any radical restructuring of the core institutions of the "cradle-to-grave" welfare state that the Labourites had established three decades before her. She was especially reluctant to take on the National Health Service, the all-encompassing health-care system that remains a mainstay of British society today. Though she attempted a few piecemeal reforms of the NHS, she notably refused to expose it fully to market discipline, all too aware that the British public would never stand for that. Nor did she attempt any substantial changes in the system of old-age pensions or unemployment insurance.

Free-market economist Milton Friedman once described Thatcher's economic philosophy as that of a "19th-century liberal," but he couldn't have been more wrong. She was a thoroughly 20th-century reformer who understood that some functions of big government defied political remedies. And there was another problem: Thatcher's hatred of socialism sometimes clashed with her urge to reduce government involvement in the lives of citizens. Many city councils in Britain at the time were dominated by far-left Labour politicians, and Thatcher often found herself persuaded to use the powers of the national government to counter them -- thus sometimes drawing London into realms where it had previously remained aloof. Critics such as journalist Simon Jenkins note that, in this respect, she often proved more closely wedded to the "nanny state" than she was often willing to admit.

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"Thatcherism Was All About Cutting Taxes."

Sort of. Britain became notorious in the 1970s for its astonishingly high rates of tax on top earners, prompting many a rock star and CEO to seek more hospitable financial climes. One of the Thatcher's first moves after her election as British prime minister in 1979 was to slash income taxes. (In 1979 the top rate was an astonishing 83 percent, which her government cut to 60 percent.) By reducing the tax burden on earnings, she aimed to unleash long-suppressed entrepreneurial impulses and to make it easier for Britons to get back into business for themselves. And she certainly succeeded. Post-Thatcher Britain has a far livelier and more diverse capitalist culture than it did before she came long.

In stark contrast to today's Republicans in the United States, though, Thatcher acknowledged that it was impossible to balance the government's books without raising revenues elsewhere -- which she did, in her first term, by boosting taxes on consumption. Though government finances during her early years received a huge boost from the flow of North Sea oil (which had begun not long before she became prime minster), the share of revenue from taxes remained high throughout her prime ministership. As Jenkins notes, taxation as a share of non-oil domestic product actually rose, from 35 percent in 1979, to 37 percent by the time she left office in 1990.

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"Thatcher Was a Dyed-in-the-Wool Social Conservative."

Not really. It was TV journalist Andrew Marr who came up with one of the best one-liners about Thatcher: "Margaret Thatcher was a child of the sixties -- the 1860s." Thatcher loved to invoke images of a halcyon Britain where people relied on their own individual initiative to get ahead, where the needy received care from private charity, and where values of thrift and hard work reigned supreme.

In many ways, however, she was entirely a creature of the second half of the 20th century. Though she was the product of a strict Methodist upbringing that emphasized individual responsibility and respect for traditional values, her record as a Conservative Party parliamentarian shows that she approved of legal abortion and also voted for a landmark law in the 1960s that decriminalized homosexuality. (To be sure, she later angered gay rights advocates with her support for a 1988 measure that prohibited schools from teaching "the acceptability of homosexuality as a pretended family relationship.") She might have found some common ground with today's U.S. Republicans over capital punishment, of which she strongly approved. Yet it's hard to imagine that her other views on social issues would have proved amenable to the American conservatives who today hold her in such high regard.

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"Thatcher and Ronald Reagan Were Political Soulmates."

Not always. There's no question that Reagan and Thatcher shared many of the same political instincts -- including a conviction in the superiority of free markets and private initiative, a suspicion of big government, and respect for organized religion. Their awareness of this basic philosophical overlap served as the basis for a remarkable partnership that has yet to find its equal in the long history of the U.S.-UK "special relationship." The common front that the two were able to build against the Soviet Union certainly helped them to navigate one of the most dangerous phases of the Cold War in the early 1980s.

And yet the public image of a serenely harmonious "power couple" obscures more than it reveals. Both were fervent defenders of their countries' respective national interests, which sometimes clashed. As Thatcher biographer John Campbell notes, Thatcher was profoundly disappointed when the Reagan administration failed to take her side after Argentina invaded the Falkland Islands: The White House pushed her to seek mediation rather than a military solution to the conflict. She also harshly criticized Reagan for failing to get the U.S. deficit under control. In the late 1980s, Campbell observes, Thatcher was also strongly critical of Reagan's "Star Wars" missile defense plan, though she succeeded in keeping her misgivings relatively quiet.

But perhaps the worst (and most visible) disagreement between the two came in 1983, when the United States invaded the Caribbean island of Grenada. The leader of the island was a Marxist named Maurice Bishop, and the Americans were worried that the Cubans were maneuvering to expand their influence there. But Grenada, a former British colony, was a member of the Commonwealth, and the British strongly objected to the American failure to warn them before the intervention. In the end, Thatcher and Reagan managed to weather the disagreement.

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"She Didn't Change All That Much."

Dead wrong. Believe it or not, some revisionists have tried to argue over the years that Thatcher's impact is vastly overrated. There are the Marxists who claim that we exaggerate her effect as an individual, since she was merely responding to the social and political conditions of her time. There are the conservative purists who insist that Thatcher didn't really change Britain in the ways that mattered. But this is an especially hard argument to make.

Andrew Marr comes much closer to the truth in his excellent TV series History of Modern Britain. "Don't think of her as a politician," he says at one point. "Think of her as a one-woman revolution, a hurricane in human form." Thatcher transformed her country beyond all recognition. During her time in office, she succeeded in dismantling the "postwar consensus" that had dominated British politics since the end of World War II. In 1945, the Labour Party won a landslide victory by promising voters a new vision of Britain based on a comprehensive welfare state (including single-payer health insurance), public ownership of key industries, all-encompassing regulation, and a prominent decision-making role for trade unions. Arriving in office at a moment when rampant inflation and industrial decline had made the limits of this model all too apparent, Thatcher proceeded to implement her own ideas of what Britain should be -- to dramatic and lasting effect. "We still live in the Britain that Maggie built," as Guardian columnist Jonathan Freedland notes. Love her or hate her, it's impossible to imagine modern Britain without her.

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