Two new papers clearly show that contractionary fiscal policy is indeed contractionary. Coming from the IMF and from an economist who had previously co-authored a paper often cited by those claiming that fiscal contractions could, in contrast, be expansionary, they are going to be hard to shake off.
The bottom line is that all those arguing for fiscal austerity now must do so on the basis that it is certain to reduce output in the short run. Thus it can be justified only by a belief that it is ‘less bad’ for the economy than postponing action, not that, – because of confidence effects or whatever other mechanism is imagined to be at work – it can actually raise output and employment.
Of course, ‘less bad’ implies a counter-factual (i.e. a situation in which Europe had not collectively embarked on austerity policies) that we lack. But recent figures and the economic outlook clearly seem to support the view of those long concerned that Europe’s economies were, on the whole, not strong enough to withstand coordinated austerity.
Most obviously, the countries in which the bite of austerity has been toughest, under the dictate of EU/IMF programs, Greece, Ireland and Portugal, continue to struggle with recession. The UK, a leading proponent of ‘no gain without pain’, which has embarked on the biggest fiscal austerity program in living memory, having emerged from recession thanks to massive monetary and fiscal stimulus, has probably suffered flat economic growth across the last three quarters as the cuts have begun to bite.
In the euro area economic sentiment and confidence indicators continue to decline. The labour market is moving sideways. Nonetheless the ECB has again raised interest rates. Although Germany is currently still expanding rapidly, the best is behind it (in German); the ifo Institute’s forward looking indicator has been falling since February of this year, and growth forecasts for 2012 are not such that Germany can be expected to serve as a locomotive pulling the European economy out of its torpor.
Meanwhile, unemployment in the US has been rising for three straight months, as past stimulus measures run out and federal states are forced to cut spending. China, Turkey and other emerging economies are also stamping on the brakes. Even if this does not lead to a hard landing, the impact on Europe will be restrictive. There is simply no sign of a substantial reduction in unemployment.
In sum, the econometricians have (re-)done their numbers and confirmed what most sensible people think anyway: if you take public sector demand out of an economy in which private sector demand is weak, output will suffer. This does not stop the European authorities calling on politicians to stay the course and, indeed, intensify consolidation efforts, most recently in their assessment of the national reform programs that brings to an end the European semester. One of the Commission‘s key findings was that “Many Member States need to be more ambitious on fiscal consolidation…”. Meanwhile the clouds are gathering over an economy that is, despite some bright spots, struggling to emerge from stagnation and offers no hope of getting the roughly seven million people added to the unemployment line by the crisis back to work.
Don’t say you weren’t warned.