Sunday, June 12, 2011

Austerity vs. Stimulus: Who is Winning the Race?

By Grant de Graf

It was George Bernard Shaw who said, "England and America are two countries separated by a common language." Today, one might describe these two financial empires as "two nations divided by a common crisis." The credit crunch brought with it a wake of independent strategies from central governments, designed to catapult economies out of the dungeons of financial doom. Remarkably, their individual approaches to resolving the crisis have been patently distinguishable and almost opposite in application. While the U.S. has adopted the classical Keynesian post-crisis approach of fiscal stimulation, Europe has chosen a course of fiscal austerity.

Keynes would have argued that it was precisely the government's policy of austerity that led to protracting the Great Depression. Only after the outbreak of World War II, which required significant levels of government spending, did the economy experience any meaningful growth. Conversely, the pro-austerity lobby argues that increasing a deficit for the burden of future generations, is financially unhealthy and undermines investment confidence. The debate over these two different approaches was initially inked in 1932, by letters published in the Times of London from John Maynard Keynes and Friedrich A. Hayek. See "Keynes vs Hayek: The Great Debate Continues"

Although Europe's embrace of austerity, may be more consistent with Adam Smith's approach to economics and his opposition to government's interference in the economy, its application to monetary policy is not. European central governments have acted aggressively in hiking interest rates in their effort to curb rising prices, a policy that is imperiled with failure. Using interest rates to control "inflation", when the "inflation" is in essence a consequence of a shortage of goods or the expectations thereof, is equivalent to using a bomb to break down an open door. See "Fool's Trap: Measuring Inflation."

Consequently, Europe has opted for the worst of both worlds, in selecting a hands-off approach to fiscal policy, where in fact the economy need's a crutch; and for active participation in interest rate manipulation, to ultimately distort the level of new investment in the economy. This will only further exacerbate an already crippled economy . The consequence of interest rate adjustment as a measure for first aid to the economy, is that it is broad-reaching and not confined to the target area requiring repair, especially when that area does not require remedy.

Secondly, the pro-austerity lobby's argument that increasing a deficit for the burden of future generations, is financially unhealthy and undermines investment confidence, is not substantiated. Everyone wants to see a reduced deficit at the end of the day. However, a crippled and devastated economy, even with a bus load of investors who are itching to participate in a promising initiative, is like scouring the horizon for buried treasure with a broken telescope.

I agree that increasing a budget deficit in times of a recession is more risky. But so is open heart surgery. In certain circumstances, there simply are no other alternatives. The real argument is whether reducing a budget deficit on its own merit, can contribute towards growth or whether the perception that it creates, will attract more investment. Even the pro-austerity lobby do not argue that there is any fundamental advantage that austerity can provide to stimulate growth, other than the positive impact that it can have on expectations; expectations that may be as consequential as sipping from a Pina Colado on a beach in Hawaii.

World Bank Global Outlook

Global Conditions
World Trade Volume (GNFS)-
Consumer Prices
G-7 Countries 1,2-
United States-
Commodity Prices (USD terms)
Non-oil commodities-24.127.620.7-12.0-9.4
Oil Price (US$ per barrel) 361.879.0107.2102.198.7
Oil price (percent change)-36.328.035.6-4.8-3.3
Manufactures unit export value 4-
Interest Rates
$, 6-month (percent)
€, 6-month (percent)
International capital flows to developing countries (% of GDP)
Developing countries
Net private and official inflows3.94.8
Net private inflows (equity + debt)
East Asia and Pacific3.
Europe and Central Asia2.
Latin America and Caribbean3.
Middle East and N. Africa2.
South Asia4.
Sub-Saharan Africa3.
Real GDP growth 5
Memo item: World (PPP weights) 6-
High income-
OECD Countries-
Euro Area-
United States-
Non-OECD countries-
Developing countries1.
East Asia and Pacific7.
Europe and Central Asia-
Latin America and Caribbean-
Middle East and N. Africa2.
South Asia6.
India 7,
Sub-Saharan Africa2.
South Africa-
Memorandum items
Developing countries
excluding transition countries3.
excluding China and India-
Source:  World Bank.
Notes: PPP = purchasing power parity; e = estimate; f = forecast.
1. Canada, France, Germany, Italy, Japan, the UK, and the United States.
2. In local currency, aggregated using 2005 GDP Weights.
3. Simple average of Dubai, Brent and West Texas Intermediate.
4. Unit value index of manufactured exports from major economies, expressed in USD.
5. Aggregate growth rates calculated using constant 2005 dollars GDP weights.
6. Calculated using 2005 PPP weights.


The World Bank reports percentage GDP growth forecast for the U.S. for 2011, 2012 and 2013 as 2.6%, 2.9% and 2.7% respectively. This is matched with a GDP growth forecast for Europe of 1.7%, 1.8% and 1.9% respectively.  Although the U.S. still remains a significant contributor to nominal global GDP (see chart below), the European Union continues to lag the U.S. in its growth and contribution towards GDP, as a percentage. Europe's application of monetary and fiscal policy together with the consequence of slower growth, is no coincidence. As long as it continues to apply austerity as a measure to resolve slow growth, together with hikes in interest rates in an attempt to combat high commodity prices, it will continue to lag other economies in its contribution to GDP as a percentage.

The ten largest economies in the world in 2010, measured in nominal GDP (millions of USD), according to the International Monetary Fund.