Austerity Policy is Spiralling out of Control

The latest unemployment statistics from Eurostat are disastrous: Unemployment has reached 11,3% on average in the Euro Area, with countries such as Spain and Greece facing unemployment spikes as high as 25% and 23%. Moreover, worse is yet to come since many economies are at this moment suffering from a double dip recession and will therefore be facing more rounds of job restructuring.

This should not come as a big surprise: High and rising unemployment is nothing else but the logical result of the fact that macroeconomic decision makers in Europe are piling up one policy mistake after the other.

First, European economic policy makers decided to go for a contractionary fiscal policy that was both ambitious and coordinated: All economies were to cut their deficits at the same time and bring these back under the 3% of GDP threshold over a period of only two to three years. However, economies in Europe trade a lot with each other. This implies that the negative impact on growth is amplified when all economies across Europe go for austerity at the same moment. In the case of joint austerity policy, member states do not only compress their own domestic demand but also each other’s export markets. Each member state then has to face both ailing domestic demand as well as export demand dynamics.

The second policy mistake has to do with the feedback effects generated by austerity. The initial round of joint austerity pushes economies back into recession and pushes public deficits back up with the result that the ambitious deficit reduction targets member states formulated for themselves are not being reached. Here, the danger is of policy opening another ‘diabolical cycle’: If policy makers stick to the initial deficit targets and introduce another dose of austerity cuts, then the economy is weakened further. In turn, this implies that not even the second dose of austerity is able to reach the deficit objectives, so that policy makers feel obliged to go for the next dose of fiscal cuts.

This second policy mistake is in the process of being made right now. In fact, Greece has already been experiencing this ‘diabolical cycle’ over the past two years, with one austerity package being followed by another after a couple of months while the economy in freefall (minus more than 10% over the 2011/2012 period). With their economies entering recession, Spain, Portugal and others are now faced with higher deficits than planned and are reacting by introducing additional cuts.

How bad could things get? A note from the French bank Natixis is providing alarming estimates. The note starts out with a rather technical analysis of estimating the fiscal multipliers for the different Euro Area countries by looking at the size of the initial fiscal austerity packages for 2012 and the extent to which these deficit targets are being reached. In this way, multipliers ranging from 0,7 (Portugal, Italy, Greece) to as high as 1,5 (Spain) are calculated. The latter figure actually means that a fiscal cut of 1% of GDP results in a contraction of real GDP by 1,5%, implying that an ex ante fiscal cut of 1% of GDP will reduce the ex post deficit by much less. At first sight, this may seem a rather high value for a fiscal multiplier. However, the recent evolution in macroeconomic theory is to point out that fiscal multipliers tend to be higher if the economy is in a deep recession, if monetary policy interest rates have reached the zero bound and if private sector dynamics are weakened because of excessive private sector debt loads. The Spanish economy indeed shares all of these characteristics and the real surprise is perhaps that the multipliers for the other countries (who are also operating far below potential) seem to be that low.

In a next step, Natixis estimates the gap between the deficit objectives for 2012 and 2013 and the expected outcomes. The gap is the highest for Spain (1,5% for 2012 and 2,6% for 2013), however, Portugal, Greece, Italy are also facing a deviation from the target of around 1% of GDP this year and 1,5% next year with France facing a 1% gap of GDP in 2013.

The final and most interesting step in the Natixis note is to combine these deviations from the deficit targets with the multipliers and calculate the amount of economic activity that will be lost if governments keep sticking to the deficit targets and impose one austerity package after the other to compensate for the negative second round effects of fiscal consolidation on GDP. The results are disastrous: Full consolidation would push the level of GDP in 2013 down by an additional 2,3% in Italy and Portugal, 2,8% in Greece and a stunning 11,8% in Spain.

As said, these are additional effects, coming on top of the actual forecasts for these countries which are already expecting these economies to shrink in 2013. Spain for example might therefore be facing a level of output in 2013 that would be 12,5% lower compared to 2011.

Even if many of these figures are based on ‘back of the enveloppe’ calculations and should not be taken as exact forecasts, the key message is clear: Austerity is killing these economies. And if unemployment is already high and rising, this is just the beginning of it. Unemployment in Spain, Greece, Portugal and other countries is set to continue to go up. It is time to put a stop to austerity and replace it with a real and tangible European growth strategy with a heavy focus on the most distressed economies.