Austerity vs. Stimulus: Who’s Right?

By Steven Hill, Social Europe Journal, November 24, 2010

To paraphrase Denmark’s Prince Hamlet, ‘To enact austerity or not to enact austerity, that is the question.’ Unfortunately, dear Hamlet, that is a question without a sure answer. The truth is, none of the experts know what is the correct thing to do. Trichet, Bernanke, Geithner, Schäuble, Krugman, Stiglitz, Wolf, Münchau, Soros, all of them are in it over their heads. In their heart of hearts, they must know it.

While we debate fiercely the question of stimulus versus deficit reduction on opinion pages and websites around the world, it is important to keep in mind that many of these ‘experts’ are the same ones who missed an $8 TRILLION housing bubble in the United States, as well as bubbles in Ireland, Spain and Britain. So in contemplating the expert’s advice, caution is advised. The global economy is an extremely complex beast, and it may have surpassed the ability of anyone to truly understand how it works. We are flying in uncharted territory, without compass or radar, surrounded by fog. Heaven help us.

Despite this uncertainty, we have no choice but to do our best to pick, if not the best course, then at minimum the least worst course. So let’s take a look at some of the arguments on both sides of the stimulus vs. deficit reduction equation.

Stimulus hawks like Paul Krugman believe that, with the drop in demand from consumer and business sectors, government is the only sector remaining to ‘prime the pump’ that will jumpstart demand and get the economy going again. There is a theoretical logic to this classic Keynesian model that is attractive, i.e. a drop in demand from two of the three major sectors requires a massive increase in demand i.e. spending, from the remaining sector. They point to the American experience during the Great Depression to bolster their claim: the New Deal’s government spending in the early 1930s stimulated the economy only to be undermined by a withdrawal of government stimulus in the late 1930s. The economy only began moving again as a result of the massive U.S. government spending that occurred during World War II, and which continued to a lesser degree following the war.

That would sound persuasive except there’s something incomplete about their narrative. As a result of World War II, all conceivable economic competitors to the United States had been destroyed in the war. So American businesses had a favourable playing field that allowed them to become dominant in their industries and contributed greatly to a growing economy. Isn’t it possible that this lack of economic competition played a major role in boosting the U.S. economy following WWII, and not just government stimulus spending? Clearly, the situation is far different today; American businesses have many international competitors, and the impact of a government booster shot may not be as potent.

From the European (as well as Japanese) perspective, whose economies and leading industries were utterly destroyed by the war, there was nowhere to go but up.  Certainly, the Marshall Plan provided a powerful boost to jumpstart economic growth, but there is no free pot of money available today. Indeed, the more the European nations spend the more they go into debt, and this has become especially problematic for the smaller nations of Greece, Ireland, Portugal and even Spain (the so-called PIGS). Whether their debt existed before the economic crisis, as in Greece, or only subsequent to the economic crisis – when a budget surplus nation like Ireland went into deep hock in order to save its banks – deficit spending has backlashed against them, resulting in much higher interest rates on bonds (the primary means of borrowing money), which cuts into their revenues over the longer term. So a nasty negative feedback loop has altered the possibilities for Keynesian intervention for the PIGS.

But larger economies like that in Germany, France, the Netherlands and others face a different dilemma. Germany is one of the few economic bright spots in the midst of this dark global storm with declining unemployment (6.7 percent compared to 9.6 percent in the U.S.) in the world’s fourth-largest economy powered by a robust manufacturing sector that has produced a sizable trade surplus. Germany engaged in a significant level of fiscal stimulus spending early in the crisis, as well as brilliantly utilised policies such as Kurzarbeit (’short work’) which prevented mass layoffs that contribute to drops in consumer spending and further economic decline.  Now that Germany is enjoying the benefits of the Merkel government’s steady navigation, this has caused some experts like economist Paul Krugman and U.S. Treasury Secretary Timothy Geithner to propose a controversial intervention for the global economy, founded on an economic theory just as divisive.

Krugman and Geithner say that the recent economic collapse was caused not only by America’s Wall Street casino capitalism but also by certain global trade imbalances. In these economists’ theoretical world, if the trading surpluses of some nations don’t balance the deficits of other nations – if their equations and spreadsheet columns don’t add up – then disaster surely awaits. In practical terms, that means that countries with robust manufacturing sectors and big trade surpluses like Japan, China and Germany (the latter two recently labelled by Krugman as part of an ‘axis of depression’) must be good sports and step up to the plate to further stimulate their domestic consumption, helping to lift the world out of its current slump in demand. They would do this by increasing their public spending and importing things from countries like the United States with big trade deficits – as soon as it can be figured out what the U.S. manufactures that the world wants to buy. And this boost in global consumption would not only provide more electronic trinkets, big screen TVs and stylish clothes for those frumpy Germans and buttoned-down Japanese, it also would help the world rebalance its trade imbalances. That’s the theory, anyway, and Geithner actually came to the recent Group of 20 meeting in Seoul, South Korea with a demand that no nation should run up a trade surplus of more than 4 percent of gross domestic product.

But as Indian statesman Jawaharlal Nehru once said: ‘A theory must be tempered with reality,’ and surely Geithner and Krugman have visited Germany and Japan and noticed the obvious: that these wealthy nations are hardly lacking in material goods or modern trinkets. So what exactly are the Germans and Japanese supposed to buy more of, especially in quantities large enough to make a difference? Americans are the only ones who seem to think they need three refrigerators, four televisions and a car for everyone in the household.

China is a different story. There, about a billion poor people could use some of the things money can buy to raise their living standards. But unfortunately the Chinese authorities think it’s better to finance the U.S. budget deficit and American consumers’ profligacy rather than the welfare of their own people. Without a functioning democracy in the People’s Republic of China, the people have little recourse to make their demand.

The impracticality of their global trade-balancing proposal reflects the unreality that certain experts inhabit. To most economists the economy is like a giant steam engine, and you can pull on one lever here and close a valve there, twist a few dials, press on the accelerator and – presto! – off you go. The levers and dials of economists are things like interest rates, money supply, stimulus spending and the like. Unfortunately, economies are far too complex for such simplistic tinkering to produce predictable results, and so economists’ efforts appear like Charlie Chaplin’s character in Modern Times, struggling to get his unruly industrial machinery to obey. The theoretical frame of Krugman, Geithner, et al. also seems to assume that not only economies, but also the national cultures in which economies are situated, can be precisely manipulated by policymakers pulling the right levers. But if we’ve learned anything from the economic collapse, it is that economies and cultures are wildebeests that tend to defy easy corralling. That’s not to say that institutions and policy are unimportant, but it’s an act of hubris to think that an economy is infinitely malleable. Policymakers face constraints and ignoring that reality results in poor policy.

Peering through the transatlantic looking glass

Part of the challenge of analysing this question, I suspect, is rooted in the fact that the European and U.S. economies have become quite different animals in fundamental ways. As a result, it’s possible that ‘one size doesn’t fit all’ in this situation. European nations have been trying to fine-tune their ‘steady state’ economies, in which, instead of relying on high growth rates like we see in emerging economies like China, India or Turkey, or even in developed but ‘trickle down’ economies like the United States, Europe has relied on developing a system that is better at broadly sharing the wealth it produces. You don’t need roaring growth rates if you have harnessed the economic engine by bridling it with attendant institutions and practices that allow you to steer toward a more broadly shared prosperity from which more of your population benefits. And during a time of cutbacks, such as the current economic crisis, the pain in Europe is more broadly distributed as well, whereas in the U.S., while most Americans have suffered, the 400 wealthiest Americans saw their net worth increase in 2010 to $1.4 trillion, an amount greater than the entire gross domestic product of India with over a billion people.

So this discussion rightly belongs to a subset of a broader discussion regarding Europe’s social capitalism versus America’s Wall Street capitalism. The transatlantic cousins have developed very different economies that may require different interventions. Perhaps America’s trickle-down economy needs more stimulus to ignite it because, absent the redistributive advantages of the European countries, you need a lot more growth so that enough of the wealth trickles down to those at the bottom. But for Europe’s steady state economies, a different intervention is needed. And that intervention, to some degree, is restoring budget sanity to their economies after a dizzying collapse, returning to sustainable levels of debt and spending so that the costs of borrowing aren’t so high. And then from that new normal, mapping out the best way to maintain this broadly shared prosperity by rejecting a wildcat economy that is built fragilely on asset bubbles. Balance and sustainability are the catchwords of this approach.

This latter course certainly seems to be what Chancellor Angela Merkel has in mind.  At the G-20 meeting, she completely rejected the entreaties of President Barack Obama and Tim Geithner for a global rebalancing of trade, or for further fiscal stimulus by her government. Instead, she gave an earful to the cowed Americans. America’s economic leadership took a major hit in Seoul, not all that surprising considering its catalytic role in bringing the global economy to the brink of disaster, its refusal to rein in its carbon emissions (despite being by far the world’s largest per capita carbon emitter) and the Obama administration’s weakened political position following the November 2 elections. The Germans, Japanese and Chinese weren’t buying any of the Geithner/Obama ‘global trade rebalancing’ proposal, nor were many of the other 16 of the G-20.

The United States is the one that must take the necessary steps to increase its competitiveness, said Merkel. The U.S. should not try to put limits on countries that have figured out how to get the world to buy their goods. Said Merkel: ‘The benchmark has to be the countries that have been the most competitive, instead of reducing to the lowest common denominator.’ Ouch, that hurts – America being called ‘the lowest common denominator.’

Her finance minister, Wolfgang Schäuble, was even more blunt. He described American policy as ‘clueless’ and said the American growth model is stuck in a deep crisis. ‘The USA lived off credit for too long, inflated its financial sector massively and neglected its industrial base.’ Ouch again. Germany – previously sneered at by U.S. pundits for its ‘weak and sclerotic’ economy – lecturing America about how to grow its economy. Right in front of the world’s major leaders, Merkel finished the process of knocking the American paragon off its post-World War II perch. The U.S. is losing the global argument over the best development model for the 21st century.  The Washington consensus is, if not dead, on life support.

The German alternative

But Merkel said something else at the G-20 that is even more of a game changer, and directly addresses the point of deficit reduction vs. stimulus. ‘It is essential to return to a sustainable growth path,’ she said. Advancing her own theory for the economic meltdown beyond global trade imbalances, she said that one cause was that ‘we did not have sustainable growth. In many countries growth was built on debt and [speculative] bubbles.’

What Merkel was saying – and it’s revolutionary in its ramifications – is that the era of U.S.-style consumption-driven economics is over. The world needs to figure out how advanced economies can provide for their people without having roaring growth rates driven by asset bubbles, and how to develop in a way that is ecologically sustainable (unlike the Obama administration, European leaders have not shelved completely their global warming interventions in the midst of this economic crisis).

If consumer-driven growth was the order of the day in the post-World War II era, in the new era of Pax Germania it will be steady-state economic growth – growing not too fast, but not too slowly – and manufacturing value-added products that the rest of the world wants to buy. Utilizing more conservation and renewable energy technologies than the U.S., Germany already has reduced its carbon footprint to half that of America’s, as well as it provides universal health care, vastly more comprehensive supports for families and workers, and has less inequality. Merkel seems to believe that her Germany is pushing reset on the capitalist development model and instead is offering a new path toward the future, a necessary corrective for 21st century capitalism.

Mr. Future, meet Mr. Past

Is the German path the correct one?  To be perfectly honest, I don’t know. But unlike so many of the so-called experts and talking heads, I am not going to snow you and pretend otherwise. Like the stimulus hawks’ Keynesian proposal, Merkel’s vision has its internal logic and appeal. Its advantage is that it seems to be grounded in a more reality-based view of what caused the economic meltdown, and is groping toward a new development model rather than returning to business as usual, i.e. the type of deficit and credit driven hyper-growth pushed by the stimulus hawks that feeds bubble-driven economies that eventually crash. It’s a development model that is better grounded in the ecological constraints of this age of global warming, as well in the challenges of identifying the practices that will allow a burgeoning global population of 6.5 billion people to share the world’s finite resources. And having a strong Germany at the core of Europe provides a solid foundation upon which to rebuild around that theory.

Certainly Germany cannot stand by and idly watch as the PIGS sink for want of a lifeline. To that end, Germany already has done much, including joining with other E.U. countries to offer a financial backstop, a kind of European Monetary Fund to help out member states in trouble, which has been used by Greece and most recently Ireland. But besides offering emergency loans, providing markets for PIGS’ businesses also must be considered as part of any vision of intra-Europe sustainability. Germany could and should do more to stimulate its own domestic consumption with a targeted strategy of spurring more buying of goods specifically from the peripheral E.U. nations. Germany’s economy is large enough to play that role for these much smaller economies without adding severely to its deficit. That’s especially true since much of this could be accomplished by paying higher private sector wages, compensating for the fact that German workers have kept their wage demands to modest levels in recent years, and relatively cheaper labour has contributed greatly to Germany’s current export boom. In addition, with Germany’s unemployment rate relatively low, the Merkel government also should think about enacting a domestic guest worker programme for Greek, Spanish and Irish workers to help alleviate the high unemployment in those countries. These sorts of plans make economic sense as well as are fitting acts of solidarity with struggling E.U. member states, and could yield modest results. But expecting the European or global economy to take great leaps forward on the basis of large increases in German (or Japanese) consumption is not a reasonable plan grounded in reality.  Rather, it is a chimera put forward by ivory tower economists playing with their economic models and formulas, thinking they can manipulate the levers and dials of the economy.

While I don’t know if the German plan is the correct one, I do believe that Germany is a remarkable country, and its current relative success in the midst of this economic crisis is one proof of that. I’ll short China and the United States before I short Germany. Since the so-called experts don’t know the correct policy response either, perhaps it comes down to confidence: in which group of leaders do you have more confidence? In Germany and Merkel/Schäuble, or in the U.S. and Obama/Geithner?

As an American, I find myself having more confidence in the Germans these days.  I would trade Obama for Merkel in a New York minute. But reasonable people are going to disagree on this point. And only time will tell, dear Hamlet, which course was correct. The history books are replete with page after page of stories about the ‘changing of the guard,’ and only in hindsight were we able to fully understand who was right and why.