Saturday, October 30, 2010

Europe's Tea Party activists - fiscal austerians?

The belief that fiscal austerity in a recession will generate market confidence and lift the economy from its depths counts along with the equally evangelical supply-side belief that tax cuts will always increase revenues as touchstones of conservative economic ideology. As the Congressional elections in the US draws near and with economy floundering at the door-step of a double-dip, the Tea Party activists are waging a vigorous battle for ideological and political dominance.

Across the Atlantic, in some respects, the austerians have emerged as the Tea Party activists of Europe. An austerity fever, nay epidemic, appears to have gripped the continent. In the face of already high and continuously rising double-digit deficits, and weak macroeconomic conditions - stagnant or dedlining output and high unemployment rates - Europe has collectively embraced a policy of re-balancing government finances. Even a cursory examination of the fiscal deficit reduction targets which have been announced by all the economies exposes them as an exercise in deception and dishonesty.

Across the peripheral economies, all the leading economic indicators look dismal, with forecasts for further reduction in output and growth in unemployment. This in turn means sharp declines in tax revenues and rise in deficits. More worryingly, the lack of private demand and near-certainty of corporate spending not being able to bridge the output deficit created by fiscal austerity, means that these economies are perched at cusp of a potentially catastrophic downward economic spiral from which recovery could be long and tortuous.

Following the recent upward revision of its 2009 deficit from 13.5% to 15.5%, Greece looks almost sure of not only not staying close to its targeted budget deficit of 8.1% for 2010 but also overshooting by some wide differential. This would not only require further debt restructuring, following the earlier $150 bn EU-IMF package, but also force more spending cuts thereby increasing the downward pressure on output and tax revenues. In the meantime the mountain of debt will grow, drawing in bond-vigilantes who will drive up the cost of financing that debt, thereby adding to the debt stock and deficits. The result of all this is predictable - sovereign defaults, deep recession (the economy has contracted 4% so far this year), and rising unemployment.

Ireland, which is set to experience its third consecutive year of economic contraction in 2010, is undertaking the most ambitious, almost unreal, deficit reduction program - to cut fiscal deficit from a whopping 32% in 2009 of GDP to a saintly 3% by 2014. Portugal is struggling to meet its deficit target of 9% of GDP, even as the economy continues to weaken. Spain faces the difficult task of slicing its deficit to 6% by 2011 from 11% in 2009 in the face of a slumping economy and the largest unemployment rate in continental Europe. Britain too has implemented unprecedented spending cuts, which look set to tip the economy into a long period of stagnation.

The fiscal austerity prescription in the face of a slumping economy and rising unemployment defies all logic and history is replete with examples that illustrate its folly. The most recent high-profile example was the IMF-driven fiscal contraction that was forced on the East Asian economies in the aftermath of the 1997 regional currency crisis. Then the austerity medicine had devastated these economies and only those like Malaysia, which went against the prevailing consensus, escaped relatively unscathed. Subsequent studies and the IMF itself have on occasions acknowledged the folly of forcing down such policies.

Paul Krugman points to another example from history, post-Depression US, when sustained public spending through the New Deal and other programs drove up government expenditures and the debt stock. However, the resultant economic growth boosted tax revenues and thereby lowered the deficits. Thanks to the recovery, even as the debt stocks rose, the deficits plunged.

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