Why austerity may be wrecking the recovery

Tamsin McMahon explains why there’s a growing chorus of opposition to the fiscal straitjacket

Squeezed to death


As head of the world’s largest bond fund, Bill Gross has the kind of voice that can move markets. For much of the last few years Gross, who runs the $2-trillion Pacific Investment Management Co., has been warning about the day of reckoning that would befall countries like the U.S. and Britain as they buried themselves under mountains of debt. In 2010, Gross declared British bonds were “sitting on a bed of nitroglycerine” and dumped his entire holdings of U.S. Treasuries with a prediction that soaring government debts would pose the greatest risk to bondholders.

This year, Gross started buying again. His flagship mutual fund is now made up of nearly a third U.S. Treasuries. These days, Gross warns that the biggest problem facing Western economies isn’t the spectre of rising government debt, but that the sweeping budget cuts countries are using to try to repair their balance sheets are killing investor confidence. Governments “have erred in terms of believing that austerity, fiscal austerity in the short-term, is the way to produce real growth,” Gross told the Financial Times last month. “It is not. You’ve got to spend money.”

Gross is part of a growing chorus of opposition to the fiscal straitjacket being imposed on many European countries in the aftermath of the financial crisis. When they were first embraced, such policies seemed like a logical solution to the reckless spending that drove half of Europe to the brink of collapse, a necessary dose of tough medicine to clear the way for future growth. But critics argue that years of tax hikes and spending cuts have instead left countries awash in unemployment, stagnant growth and mounting debt.

Eurostat, the statistical agency of the European Union, released revised economic growth figures last week showing that even though its member countries have slashed their budget deficits nearly in half since 2009, their debt-to-GDP ratios have ballooned from 80 per cent of GDP to 90.6 per cent as the economy grew at an anemic rate (less than one per cent last year). Job growth has also been non-existent. Unemployment is now at a record 12.1 per cent. Austerity, it seems, has neither spurred a recovery nor fixed balance sheets.

Protesters took to the streets of Greece and Spain last week to demand an end to austerity. Italian Prime Minister Enrico Letta pledged to reverse a series of tax hikes, declaring that “Italy is dying from austerity alone.” In France, Finance Minister Pierre Moscovici promised to end the “dogma of austerity,” saying it has harmed economic growth.

The fierce opposition has even inspired a bevy of anti-austerity literature. David Stuckler and Sanjay Basu, researchers from Oxford and Stanford universities, argue in the forthcoming The Body Economic that austerity has become a public health problem, with rising joblessness and cuts to health and social programs responsible for everything from rising alcoholism in Britain, to an HIV epidemic in Greece. That country has even seen an outbreak of malaria because of cutbacks to budgets for mosquito spraying. “Recessions can hurt,” they write, “but austerity kills.”

The backlash is moving across the Atlantic, where despite massive stimulus spending from 2009 to 2011, a recent shift to austerity is causing concern. Automatic budget cuts in the U.S. have been blamed for everything from a slowdown in hiring in March, to flight delays because of furloughs affecting air traffic controllers. In Canada, the parliamentary budget officer warned that Ottawa’s plans to balance the budget in time for an election in 2015 would sacrifice as many as 62,000 potential new jobs over the next three years and cut GDP growth by 0.12 per cent.

All this is shaping up to be one of the most important economic debates of our time. If the anti-austerity movement is right, the global economy is being strangled at a time when what it needs most is a boost. If they’re wrong, and austerity is abandoned too soon, the debt crisis could haunt the world for decades to come.

Opponents of austerity have been winning some powerful, not to mention surprising, allies recently. The International Monetary Fund, previously one of the leading voices in favour of austerity, did an about-face last month, using its World Economic Outlook to urge countries to scale back on their austerity plans. It called on Britain to introduce greater “flexibility” in its plans to slash its deficit to one per cent of national income by next year despite narrowly staving off an unprecedented triple-dip recession.

This week, European Central Bank president Mario Draghi announced he would be willing to slash interest rates to “less than zero” after the bank cut them to record lows last week—a clear sign that the bank believes fiscal austerity alone has failed to stabilize struggling economies. European Commission president José Manuel Barroso, meanwhile, declared that while austerity was still “fundamentally the right thing to do,” the policy had “reached its limits” of political and social support. That has left Germany as the lone voice of austerity in Europe, with Foreign Minister Guido Westerwelle warning that persistently high debts will only “cement mass unemployment for many years.”

In what is being held up as the most significant—if largely symbolic—blow to the austerity movement, a graduate student at the University of Massachusetts uncovered serious flaws in widely cited research by Harvard economists Carmen Reinhart and Kenneth Rogoff that claimed a country’s economic growth began to suffer when its debts topped 90 per cent of GDP. The two economists argued that their research hadn’t even attempted to clear up the long-standing debate over whether it was high debt that caused economic growth to slow, or poor economic growth that caused debts to rise. While it’s largely an academic controversy, critics have claimed it as decisive proof that, as economist Paul Krugman wrote, “austerity had been sold on false pretenses.”

For a time after the financial crisis, the world seemed pretty much in agreement on the right thing to do to guide economies. After 2008, when the U.S. subprime mortgage crisis morphed into a global banking disaster, governments agreed to spend their way out by nationalizing toxic financial assets, slashing interest rates and unleashing trillions in stimulus spending.

Perhaps they were inspired by the barren landscape of Canada’s Far North, but by the time finance ministers from the G7 met in Iqaluit in February 2010, the pendulum of political opinion had begun to swing in the opposite direction. Having stimulated away the worst of the recession, it was time for governments to get their balance sheets in order.

But these days, despite the noisy opposition in Europe, there is hardly any consensus on whether austerity is good or bad medicine for an economy struggling to find a cure for recession and mounting debt. Proponents say that what is failing Europe isn’t fiscal austerity, but growth-killing policies like tax hikes, or threatening small depositors with losing their savings as officials initially proposed as part of a bailout for Cyprus. French President François Hollande’s plans to fix the economy included a 75 per cent tax on millionaires that was ruled unconstitutional in December. By contrast, Baltic countries—Latvia, Lithuania and Estonia—made deep spending cuts in the wake of the 2008 financial crisis and have seen some of the best growth in Europe.

“People say austerity didn’t work, but what austerity?” says Niels Veldhuis, who heads the B.C.-based Fraser Institute. “If you look at Portugal, Italy, Ireland, Spain, they have all increased their spending. We’ve got to be very careful when you say austerity hasn’t worked in Europe. It’s simply not true.”

Yet opponents of austerity argue that cutting government spending in the midst of a global recession can send a country’s economy into a death spiral. Slash spending, they say, and you cut jobs, which drives down wages and increases unemployment. That kills consumer demand, which in turn hurts investor confidence. The result is that government spending falls, but economic output falls faster, causing a country’s debt-to-GDP ratio to balloon despite austerity measures.

That can morph into long-term unemployment with huge consequences for economic growth, says Michael Mendelson, a senior scholar at the Caledon Institute of Social Policy. “People have this sense of a morality story where we’ve spent, spent, spent and now we have to suffer the consequences. But it’s not a morality story. It’s a question of what are the numbers,” he says. “Some of our future advantages are being sacrificed now in the search for short-term savings, even if those savings may not have much of in impact on our debt burden anyway.” Others go as far as to say that austerity represents a form of class warfare, since it’s wealthy investors who benefited the most from governments’ decisions to guarantee the risky debts of insolvent banks, while regular citizens bear the brunt of tax hikes and cuts to programs. “What you’ve managed to do is a bait and switch with the debts of the private sector ending up on the public balance sheet and magically recast as excessive government spending,” says Mark Blyth, professor of international political economy at Brown University and author of Austerity: The History of a Dangerous Idea.

Budget hawks, on the other hand, like to see austerity as the start of a virtuous cycle. Governments that trim their deficits can lower borrowing costs, making their debts even cheaper to pay off. That boosts the confidence of investors, who then pour money into an economy. Too much debt, they argue, can become a broader economic problem if borrowing costs become unsustainable, causing a government to default and sparking a run on banks that hold government bonds. “Once you have a better fiscal performance, investors look at that and say this country is being prudent and therefore that’s a place where we want to invest,” says Veldhuis.

Supporters of this idea of “expansionary austerity” have argued that how you cut is just as important as how much and that the wrong fiscal policy can plunge a country into economic collapse, while the right one can stave off a recession altogether. For instance, Veldhuis argues cuts to education can be damaging to an economy, since such spending improves the skills of the labour market. Cut business subsidies, on the other hand, and “you can actually get very positive results.”

One of the most frequently cited examples of successful expansionary austerity is the budget-cutting of the Chrétien Liberals in the mid-1990s. By slashing department spending and public sector jobs, the government returned the federal budget to a surplus in three years after nearly three decades of steady deficits, and also saw the start of an economic expansion.

Slaying the deficit made room for the government to cut taxes, which made Canada a more attractive place for investors, says Veldhuis. “We made Canada much more competitive, and what happened when we did those things? Canada was a superpower in the world,” he says. “Austerity does actually lead to a better fiscal climate.”

But Mendelson argues that Canada’s success in the 1990s had less to do with austerity creating a pathway for growth than economic growth creating an opportunity for austerity. By the time the government began its economic reforms in 1995, the economy was already growing by five per cent a year, thanks largely to exports to the U.S., which was in the midst of an economic boom.

The lesson from Canada’s experience, says Mendelson, is that austerity only works when your major trading partners are growing, not in the midst of a global recession and not when all of your neighbours are also cutting back on their spending. “You’re going to have nobody spending and then where is the economic activity going to come from?” he says. “You can’t float a boat at low tide.”

The current battle over austerity strikes at the heart of the broader debate on the government’s role in the economy. Should governments try to create jobs, or get out of the way of those who do? Can they stave off a recession or merely respond to it?

Despite centuries of economic data—Reinhart and Rogoff’s controversial analysis spanned 200 years—that debate is far from over. Until countries can experiment with fiscal austerity in a global economic vacuum, it’s a debate that may never be settled.

“When researchers tested Prozac on depressed patients, they divided their subjects randomly into control and experimental groups, and conducted many trials,” says Yale economist Robert Shiller. “We cannot do that with national debt.”


Why austerity may be wrecking the recovery

  1. >> “When researchers tested Prozac on depressed patients, they divided their subjects randomly into control and experimental groups, and conducted many trials,” says Yale economist Robert Shiller. “We cannot do that with national debt.” <<

    One can look to history. After WW2, governments had much greater debt, yet still used the Keynesian method of fiscal and monetary stimulus to promote a strong economic recovery. The strong economy enabled governments to pay down most of their debts. In Canada, we paid down debt from 100% to 17% by the mid-1970s (now 88%.) The US paid down theirs from 135% to 35% (now 107%.)

    Austerity kills GDP growth. Debt is measured in debt/GDP. Therefore, using austerity to reduce the deficit in a slump is like quitting your job to pay your debts. Countries who have tried this ended up creating recession and bigger deficits.

    As Keynes said 80 years ago, "The boom, not the slump, is the right time for austerity."

    • Huh? I don’t think anyone can seriously compare the US and Canadian economies of the post WWII period and today. What grew the economies after WWII was the powerful manufacturing base that had been developed during the war, pent up consumer demand, and rapidly increasing exports. Although the Goverment helped (with GATT & ITO), attributing the postwar economic expansion mostly on Keynesian economic policies is wrong. We made things, good things, that the world wanted. Today we make very little and play games with finance. We print money and incur mind boggling debts that future generations will have to repay.

      Another big difference between the post WWII era and today is who actually owns all the gov debt. Back then, most gov debt was purchased by citizens of the issuing country (War bonds, Treasury bonds). Today, the largest owner of US debt is China. After WWII, people in the USA who had bought the War Bonds (to help their country during a time of war) further helped their country by liquidating those bonds and buying stuff, stimulating the economy and creating jobs. I don’t think the Chinese have the same goals.

    • Well, to be fair we didn’t have that many billionaire leeches skimming off most of the cream for themselves back in the day. And the ones we did have seemed to have a more developed sense of communal responsibility.
      Govt by the people for the people seemed to actually mean something too.

      • What we’ve got now is a mix of political dynasties (based on career politicians) inbred with corporate feudalism.
        This is a direct result of goverment being too large, controlling too much of the economy. This gives a large incentive for uber-rich or big corps to tilt the playing field in their advantage but simply nudging their favourite politician to regulate their competitor out of business rather than having to out compete them.

        • So absence of govt or a far more limited one would then equal ethical behaviour on the part of uber rich and mega business, would it? I very much doubt that myself. The problem is unethical individual behaviour, not too much govt regulation.

    • Keynes was just wrong, time to get over him.

      100 million invested by the gov’t will not stimulate the economy as much as 1 dollar invested by 100 million people.

      Want recovery in the slump, encourage the people to invest.
      Want to go further in debt, well – just keep gov’t spending going up, up, up.

      Saving for a rainy day during the boom is not a bad idea for gov’t or people, but it must not leech the economy and it must not lead people to believe the gov’t can spend their way out of the slump either.

  2. Well,well, well the “message” is finally getting through.. though it took a lot of “little people” pain to get there.. Bravo I say!
    The economics is simple.. overcoming ideology is not so simple..

    • Keep the money in the hands of the taxpayers rather than “spending” it on frivilous public services only makes sense. When the economy truly is better, taxpayers will naturally spend again. Confiscating then spending taxpayer dollars to make the economy “appear” to be healthy again only makes matters worse.

      There is no argument against austerity. There never was, even in “good times”. If we had been “austere” in good times, things would have been better now with taxpayers having more money to handle the bad times.

      • “Frivilous [sic] public services.”..like roads and bridges, infrastructure, educational institutions, health care and such like eh!

        • Of course, just like Obama – when cuts need to be made go after the most essential services in order to promote maximum public outcry. Forget cutting the crap, let’s fire some firefigters.

          We’ve tried government spending to oblivion, it didn’t work. We printed money, it didn’t work. We cut the essential services, that didn’t work either.

          Hmmmm what to do..

          Rather than try the obvious the socialists prefer to go back to the beginning.

          The obvious, which they are not trying, is cut taxes to encourage private risk taking and investment.

          But socialist can’t understand that it is private sector that grows the economy, not the gov’t.

          • Yeah right…Bush implemented huge tax cuts, mostly at the top end, but still he cut them and congress insisted Obama keep them. Unfortunately Bush kept spending, and the crash left Obama arguably with little choice but to keep on stimulating the economy. [ i don’t follow US politics, so i have no idea what all the firefighter stuff is about]
            As the article makes clear [as was the case with the 90s liberals] it is when you cut as much as what you cut. Luckily for Canada the US economy was going well when we cut so we could grow our economy as we cut.
            Drastic cuts when there is no prospect for economic growth is just voodoo economics.

          • Blame Bush – really, that is getting a little old don’t you think?

            Reducing taxes DOES NOT equal spending! Taxes are a leech on the economy, they do NOT stimulate the economy.

          • You missed the point – Bush cut taxes AND continued spending. How is that not his fault? I’m not letting Obama off either. He will be remembered as the Prez who sent no one to jail for ripping the nation off. Just as bad in my books.

          • I disagree. If one reduces taxes, one directly injects cash into consumers hands, therefore banks and business. The opposite of trickle down is buying up. Heck if I got half the taxes I paid back I would have done my fair share of stimulus spending. Plus, atleast the individual can decide where and what is worth investing in.

          • Government spending is not the same as individual spending.

            First, most people have to work for their money so are not as likley to frivolously through it away, unlike gov’t. In other words, people usually look for a deal, gov’ts do not. Private money looking for deals spurs economic competition and make the economy healthier overall.

            2nd, most people have limited budgets and understand that they have to spend within those budgets, so their expenditures are prioritised according to what they need first, then what they want.

            3rd, as you mention, people don’t always just spend – many look to invest. Investing and spending are entirely different. Private investment is what drives the economy, not gov’t.

          • “– cut taxes to encourage private risk taking–” unfortunately private citizens are usually focused on their own well being and totally unconcerned about the overall economy. The only thing that encourages risk taking is the promise of large rewards — in the absence of that the individual will just put the money under the mattress.

          • Well, duh – the risk -reward ratio is what drives the economy, everyone’s economy.

            That is why taxes artifically skew this ratio and people decide it is just not worth it to invest. Money in the mattress, economy stagnates or shrinks – it is obvious.

            If you truly want the economy to grow, then this leech called taxes must be reduced to minimum so that people take their money back out of the matrres and invest it.

            Increase in gov’t spending will not encourage people to invest, in fact just the opposite cause everyone knows where the gov’t money comes from. It comes from tax revenue, so it doesn’t take a genius to figure out if spending goes up so must taxes – hence people again just hold on to their money.

            Want to see where centalised planning takes you, just go look up the
            history of all communist countries. It generally ends with piles of

          • Frenchie, get a grip. You know anything about real business at all or are you caught up in the magic land nonsense about how investors are waiting for the taxes to go down.

            Snap Quiz:

            You’re thinking of a lunch stop restaurant in your town, You get to pick between :
            1. lower taxes for your restaurant earnings, and given all the closed down shop fronts and offices those earnings are going to be minimal. You’re going to really have to fight for every plate.
            2. a guaranteed flood of hungry customers working on government projects.

            Think about this carefully. Like a business man would. Would you be willing to pay slightly more in tax but in return get a flood of customers? It’s about 40% of a lot versus 20% of nearly nothing. Now which do you think a real savvy businessman would choose?

            Do the numbers and then ask yourself how in earth you ever came to believe in such nonsense, this confidence fairy claptrap. .

          • Your strawman is flawed, I choose neither,
            I pack up shop and go somewhere with reputable clients that aren’t being paid with my hard earned money going into taxes.

            You see, that’s how investors work. Capital can move freely, and so it does and usually to places with lower taxes,

  3. Nicely done Tamsin. Eminently tweetable.

  4. I hear faint and distant echoes of Baker, Krugman, Delong,
    Thoma, Stiglitz, and a dozen other non-entities moaning in
    the background as we listen with disbelief to a … bond dealer.

  5. Does it honestly surprise anyone that the world’s largest bond dealer wants governments to go further into debt? Talk about history repeating as farce…

    Private and public sectors are both dangerously overindebted. The author does not mention the one major idea circulating that avoids increasing debt overhead costs: a massive, controlled credit writedown or a Debt Jubilee.


  6. Austerity is the brain dead approach to controlling government spending — but the alternative — an intelligent focus on the effectiveness of programs, the expansion of ones that work, and the ending of ones that don’t — is hard, and tends to make the head hurt if you’re a politician who got elected by looking good or a senior civil servant who got there by kissing nether parts.

    What cutting the funding for a government department in the absence of oversight or intelligent planning does is cause the senior bureaucrats of that department to protect their own turf (and butts), and cause the most pain they can to the citizenry in an attempt to get the funding restored. In short, they cut at the bottom where services are actually delivered and maintain the waste and inefficiency that surrounds themselves with assistants and sycophants.

  7. “Budget hawks, on the other hand, like to see austerity as the start of a virtuous cycle. Governments that trim their deficits can lower borrowing costs, making their debts even cheaper to pay off.”

    Wait…is this actually the argument? How is austerity supposed to lower borrowing costs when in most countries outside the Euro they’re already basically at zero!

    As for the Canadian precedent, the whole point of the Chretien/Martin cuts is that they were done once the economy was already growing, not in the middle of a recession.

    • So – your argument is that borrowing costs are not an issue since “they’re already basically at zero”? Sorry, basically at zero doesn’t mean much when we are talking the debt load numbers out there today. The US debt at over $16 Trillion grows around $3.5 billion a day. That is over $2 million every minute, even at today’s low interest rate environment. Lord help the US when rates are forced to rise (failed treasury auction). Servicing that debt will be a huge drain on their economy; and, since we are so closely connected – ours.

  8. No economy, personal or national, is sustainable as long as it spends more than it earns. Continuing to mortgage the future to pay for the present is no different from racking up gambling debts on a credit card. Yes, austerity may mean some belt tightening now, but failure to get our finances in the black will simply lead to a greater collapse down the road.

  9. The fact of the matter is–there is not, and hasn’t been, any “austerity.”

    So the whole premise of the article is nonsensical.

  10. Bill Gross’ arguments flip back and forth depending on whether he is long or short.

  11. Companies have found over the past 3-4 years that they can get by with less employees.
    which means less personnel and payroll staff…..they do not bring in any money to the company’s coffers Not interested in hiring millenium kids….who cannot do their job without someone holding their hands and have to do the job(s) for them….this is why so many young people are becoming self employed….

  12. “Austerity” is just a word to the general public who have been struggling already,….how much money has been salted away overseas by those who use that term when talking about the programs that matter to the general public? Keynesian methods make more sense, but who has heard of a recent Canadian government that believed in that approach while they were busy “making it for themselves”? Stop and think, how many fiscal scandals have we been dealing with in the news, lately, and how many other wasteful situations that are being used in the wrong areas will ever reach the public ear? “Austerity” is just a big word to cover up the deceit of pennalizing the poorer segments of the Canadian public, while the government pretends to be knowledgable,….it is NOT an over-statement to say that this so-called austerity is going to end up on the backs of the poorest segment of the population,….why do the numbers of homeless keep increasing,…why are so many people on anti-depressants,…so many questions,….while the government is too busy covering it’s _ _ _!!

  13. It isn’t austerity killing the western economies.

    What is killing the western economies is excessive non-value added government consumption and corruption all funded by debt and currency fraud. You can’t have excessive government consumption exceed the value of production, it will eventually collapse. And just printing more money to devalue currency and get more debt and bailout fraud is well, not leaving enough value for the productive.

    The more QE fraud, the more they print, the worse it gets. Government can’t solve the economic problems as their fraud and denial policies are the problem. Keynes, Bernanke doctrine, just fraud economics. Bernake got in office, and shortly after he printed money to devalue USD, the economy collapsed. Look it up!!! Stop trusting corrupt government, the facts are there.


    Just a fact your leftist statism types don’t want you to know. We have governemtn far too taxing for a decent economy. Far too much govmint cunsumtion and not enough for productive people. Need to reduce consuption and get more social assistance abled a working, including welfare, FN, EI and immigration…..and reduce government.

    Leaving more for producers will drive the economy. Bailing out banks, GM, Air Canada and others is just dirty and corrupt abuse of taxpayers.

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