The Fairy Tale of Expansionary Austerity

The hypothesis of expansionary fiscal contraction dates back to the early 1990s. According to this hypothesis austerity might have expansionary effects in cases where households trust government efforts and think that today’s sacrifices will translate into tax reductions in the future. These expectations on their future disposable income might induce them to increase consumption and investment in the short-term, leading therefore to expansionary effects.

During the 1990s many OECD countries opted for structural adjustment and spending cuts, experiencing good levels of growth and no increase of unemployment over the considered period. Today’s supporters of austerity policies in Europe often make reference to this consolidated narrative, especially with reference to the Canadian and Swedish experiences. The perception of success has remained quite unchallenged so far, providing fuel to the supporters of welfare and public sector downsizing. It is usually underlined how successfully Canada reduced its deficit of 7 points between 1994 and 1998 by aggressively cutting social expenditure, while experiencing at the same time a fall in unemployment of 4 points and GDP growth steadily above 4% between 1997 and 2000. The same happened in Sweden which, in the aftermath of two major recessionary episodes accompanied by high public debt, started a fiscal consolidation programme in 1994 and thereby experienced a decrease of unemployment of 3 points by 2000 and high GDP growth since 1997. But two questions arise: firstly, is today’s global economy under the same macroeconomic conditions of the 1990s? Secondly, which parameters have been used to deem successful the Canadian and Scandinavian approaches in that decade?

The answer to the first question is clearly no. Contrary to the orthodoxy of the expansionary austerity hypothesis, there are a number of non-policy induced variables which are of paramount significance for the economic performance of countries undergoing austerity measures. Among these variables there is first of all external demand. Between 1994 and 1998 the US, as Canada’s main trading partner, grew annually by 4% on average with households domestic demand growing by almost 20% over the whole period. Furthermore, the implementation of NAFTA contributed to pushing Canadian exports to 45% of GDP by 2000. Finally, the Canadian dollar dropped against the US Dollar over the period. Similar dynamics occurred in Sweden, which accessed the EU Single Market during a phase of 3% growth for the Union. As a result, the Canadian current account shifted from -2% of GDP in 1994 to 3% in 2000, whilst the Swedish current account rose from 1% of GDP in 1994 to 4% in 2000. But embarking on austerity all together in a currency union is a different story. Even if the PIGS’ main trading partners – the surplus eurozone countries – are growing, their growth is export-led, unit labour costs are not on the rise, and households’ propensity to save shows no signs of decreasing. Additionally, the countries under adjustment share the same currency of their would-be export outlet.

As for the second question, the success of the Canadian and Swedish experiences has been measured only against a rather narrow bunch of parameters such as growth and public debt, leaving aside the impact of the programmes on private debt and income inequalities. The cuts in Canadian government expenditure translated into a sharp inequality increase with the Gini coefficient growing by 22% between 1994 and 2000, leading to a growing indebtedness of Canadian households. Between 1994 and 2000, Canadian household net lending/borrowing fell from 7% of GDP to 0%, and kept on decreasing to -4% until the eve of the crisis and reflected the same trend as the US: welfare retrenchment led lower income households towards debt, making growth largely stock market bubble-driven with the consequences we experienced in 2008. Since the 1990s Sweden, despite being among the OECD countries with the lowest levels of income inequalities, has also been the OECD country with the fastest acceleration of the Gini coefficient (31% between 1994 and 2000).

Assuming that private debt is a way to reduce social unrest, one should first question whether it is possible in the current situation of tight credit, and second whether it is desirable given the damage it created for the global economy. Is this really the type of “success story” the eurozone should look at?

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  1. Katherine Huthmacher says

    Also worth noting in Canada was the downloading of budget expenditures to lower levels of government which were unable to cover them, leading to deterioration of healthcare, transportation infrastructure, education, environmental protection, city services, poverty support, housing, public broadcasting, culture and much more. Unemployment levels also remained relatively high during the 90s despite economic growth.