Tight and Trim Now, Lean and Mean Later?: The Debate on Austerity and Adjustment in Tough Times

The World Bank-IMF Spring Meetings that I attended last month focused quite heavily on the prospects for the world economy as well as several debates on the policy challenges faced by governments in countries still reeling from the economic crisis.

 

The session titled ‘Narrow Path for the Global Economy’, hosted by the IMF and moderated by veteran TV anchor (PBS/Bloomberg) Charlie Rose, particularly stood out in that it provided a vivid snapshot of the critical ongoing debate – can tough adjustment and structural reforms be done in the developed economies even while their citizens are facing tough economic times? Opinions were diverse and the debate was vibrant, as was clear from the panelists’ comments. Let me capture a few of the perspectives shared by them; but first a quick overview.

 

 

The IMF managed to successfully amass a US$ 450bn fund as a firewall to contain any contagion effects of the Eurozone spreading elsewhere in the world. Despite much hesitation by developed and emerging economies alike in contributing to this fund, Japan stepped in with a large contribution, which in turn opened the gates for substantial support from other countries. This was crucial to give markets confidence. The Eurozone woes had begun hotting up once more (and has since got worse with talks of a Greek exit from the EU – or “Grexit”!) and the IMF was keen to show that measures are in place to provide financial support if required. As IMF Managing Director, Christine Lagarde herself put it, “Recovery is on the horizon but the dark clouds haven’t dissipated”. She pointed to a notable jobs and manufacturing recovery (particularly in the US), but slow protracted growth across the West along with high unemployment.

 

Quite surprisingly, there was even discussion on whether countries may need to pull back from the current austerity drive in case it further fractures an already fragile recovery. Lagarde advocated for “fiscal consolidation along with growth promoting policies”, but noted that the Eurozone hasn’t got this balance right. This was essentially the debating point – should the Eurozone and also America push further on austerity in order to get their fiscal house in order? Or will pushing it any further tip the economy over the edge and back into serious recession? Well, as for the Eurozone, the latter was answered. Last week came the news that, apart from Germany, the rest of the Eurozone has gone back into recession.

 

Tighten Now for Strength Later?

 

A key personality who has been warning against tight austerity has been Christina Romer, currently, Professor of Economics at University of California, but more notably, the former Chair of President Obama’s Council of Economic Advisors. She cautioned against further belt-tightening in Europe saying that “if Europe gets much worse, it will hit the US recovery”. She reiterated that, “Europe has moved far too quickly on austerity and we can see the results – unemployment in Spain is 25%. No amount of tough fiscal reforms would fix things right now”.

 

A key part of this debate was whether countries should undertake the tough reforms – particularly on the structural side of the economy like labour markets, regulations, education, innovation, etc. – right now, despite of the tough times, in order to have a stronger, leaner economy emerging out of the crisis. They posited that such an approach would benefit medium- to longer-term growth and put these economies on a stronger footing.

 

Mexico’s Central Bank Governor Augustin Carstens pointed out that, “Once countries commit to strong enough adjustment through austerity, markets believe it is sustainable, markets get confident that the government has credible policy and implementation. Countries can go back to them, and goes from vicious cycle to virtuous cycle – you need to get to a point where markets believe it is enough to put economy back on right track”.

 

Meanwhile, the Minister of Finance of Sweden, Anders Borg also advocated on undertaking structural reforms despite the tough economic times – “when you’re out of money and out of growth….you have to do the structural things”. He asserted that, “countries that kept their houses in order without crazy stimulus like Sweden are now back on track, whereas in Spain and UK where there was heavy stimulus, they’re in dire straits now”, he asserted. Despite her comments at the start which questioned whether there’s too much austerity right now, Lagarde seemed to agree with Borg – “Front load the adjustment now”, she said. She argued that because Sweden and Germany had already done the structural adjustment pre-crisis it helped them weather the crisis better.

 

Romer, on the other hand, continued with notes of caution, “Unemployment has been high for years, interest rates have been low and they can’t be used to stimulate the economy. Space to make adjustments is much less. So austerity right now is particularly tricky”.

 

Getting more specific on what kind of structural reforms are required to get back on track, Mexico’s Augustine cited competition, law and order, human capital, and industrial policies as key policy areas. But he also warned that countries must guard against any “temptation towards protectionism” as a way out of the crisis. “We need to renew our commitment to free trade. It’s not just goods and services but also more space for investment”, he said.

 

Meanwhile, the only panelist from Asia, the Governor of the Reserve Bank of India, Duvvuri Subbarao, stressed that governments must not lose sight of the imperative of inclusive growth, amidst this austerity and adjustment debate. “Across towns, villages and cities in emerging markets, the inequality debate is coming up. On top of growth and financial stability we need equity and inclusion”. Lagarde agreed – “growth not sustainable if it doesn’t create jobs”, she remarked. She hit out at the financial system and the need for managing it better – “We need a well functioning financial system that operates in the public interest – they have a duty to society. They must focus on their main role which is to finance the economy, more than other things they are doing”.

 

No Clear Consensus

 

There was no clear consensus among this top group of leaders and thinkers, but it’s only to be expected. Romer worked for Obama who was very keen on stimulus and fought back austerity pressures quite vehemently. Anders Borg, on the other hand, was able to advocate for stronger adjustment and reforms because Sweden isn’t in the doldrums as much as the rest of Europe, and pushing adjustment would naturally be more politically feasible. Meanwhile, Lagarde is walking a tightrope between advocating for more belt-tightening to ensure debt sustainability and stable macro management, while also having to consider the obvious impact it can have on weak-recovery economies and the threat of further recession that is looming large.

 

So, it is clear that the jury is still out on whether now is the right time, or not, to aggressively push austerity and boldly make structural adjustments. It is also clear that anti-austerity sentiment is creeping throughout Europe, and it has already manifested itself politically. The Dutch Prime Minister had to resign after losing a vote of confidence on proposed budget cuts. Sarkozy lost to Hollande, the first socialist President in France in a generation, because the French people decided that austerity wasn’t working for them. Greek governance is in limbo after the new Prime Minister was unable to form a coalition government, with a key potential ally refusing to be part of a pro-austerity regime, forcing Greece to go back to general elections for the second time in as many months.

 

However, as each of the panelists revealed, there are several reasons to be optimistic. As Christina Romer pointed out, America is making steady progress towards recovery and the signs are positive. On Europe, she quipped, “as dysfunctional as it might be, the marriage is still holding, it’s not a divorce!”. Anders Borg said that the “Triple A” is his reason for optimism – a resurgent Africa, growing Asia and recovering America. Meanwhile, Subbharao was of the view that institutional change and reforms will happen in emerging markets sooner than later – “the rise in aspirations of people in emerging economies – that alone is going to drive governments and international institutions to take action”.

 

Overall, it is safe to say that no one knows how the next few months will pan out. A comment by Christine Lagarde captured this ambiguity well as she said that her ‘weather forecast’ for the global economy was one of “light recovery, spring winds, and dark clouds”. But, the policy challenge for the many developed countries, particularly in Europe and the US, is one of balancing austerity with growth. Policymakers there are grappling with questions of: “how much should we tighten without suffocating the economy? Will trimming the fat now guarantee a leaner, meaner, more competitive economy in the future?”


  • Eshini

    It was great reading this! I am not sure how well this Keynesian argument fits the data but at the ZLB the Euler equation displays a positive relationship with inflation and output as inflation is unresponsive to policy so the only way to stimulate the economy is by a simultaneous increase in government expenditure and taxes. Though i do agree fiscal consolidation would help with investor confidence in markets, output would respond to such a policy without the need of severe austerity measures.

  • Ashani

    Thanks Anush for a very timely and engaging article on the propects for the global economy. The debate between austerity and stimulus measures seems to be an extremely tricky one. As you point out, while acknowledging the crucial need for austerity measures, given Europe’s fallback into recession, it may not be the best option at present.

    On the other hand, signs of improvement in the US suggest that now may be the time to undertake tough reforms in its economy. Of course, with the upcoming elections in the US, strict austerity seems highly unlikely in the near future.

  • Malathy Knight
  • deshald

    it all comes down to politics in europe. it is simply not politically sustainable to have drawn out austerity in countries with high unemployment (specially youth unemployment – spain at over 50%).

    the entire european monetary integration project is based on a weak structure – it imposes monetary uniformity on countries with vastly different economic structures, and without the necessary fiscal integration to address such imbalances.

    the fundamental problem is that prolonged loose monetary policy (ok for germany but not for greece, spain, italy etc) contributed to deteriorating competitiveness of southern european countries creating big current account deficits whilst germany and others generated large current account surpluses. germany in turn has had to finance these deficits (putting pressure on their financial system). the only way to re-dress the current account imbalance is for the peripherals to undergo a prolonged deflation with high unemployment and for germany to accept higher inflation – both of which, considering their respective histories as well, are very very politically unpalatable.

    i feel there will eventually be some form of euro break up (either one or several countries dropping out) and the real question is how far it can be contained. would be prudent for us to think about how we respond (as a country and at more micro levels) to such an eventuality.

    michael pettis puts it succinctly in this piece

    http://www.mpettis.com/2012/05/18/europes-depressing-prospects/

    michael pettis

    • Anushka Wijesinha

      thank you, deshald. these are very valid points. even though people like Lagarde and Merkel reiterate that the ‘political will’ to preserve the euro project is very strong, economic pragmatism and domestic voter pressures may put this severely to the test. we will have to see how it pans out, but I agree, Sri Lanka needs to watch keenly. Our whole export model would have to be retooled and reoriented to suit emerging markets, moving away from the US and EU which were relatively “easy” for businesses to work with.