Austerity has measurably damaged Europe: here is the statistical evidence

Recent damage from riot
protests against the cost of living in Paris.
BENOIT TESSIER/Reuters

• The Institute of International Finance says austerity
  probably damages economies trying to recover from the great
  financial crisis.
• Since 2008, GDP growth in the US has been 10% greater
  than in Europe, the IIF says. In terms of GDP growth per
  capita, the reduction was 5%. Fiscal tightening in Europe was
  the main difference.
• Trend growth in the US was double what it was in Europe
  following the financial crisis, the IIF says. Prior to 2008,
  they had been the same.
• “Fiscal austerity is a mistake,” IIF Managing Director
  & Chief Economist Robin Brooks tells Business
  Insider.

Since the great financial crisis of 2008 there has been a debate
about what the right plan for economic recovery should have been
across the US and Europe.

For conservatives, fiscal “austerity” was the answer
— limiting debt, deficits, and consequently government
spending, in order to put the economy on a sound basis for future
growth.

The left, by contrast, argued that fiscal spending was the
solution — using the government to supply the investment money
that disappeared in the private markets during the crash, thus
priming the pump (but at the risk of funding it with more debt).

Now, the Institute of International Finance has published a
series of research papers showing that austerity was probably the
wrong choice. Fiscal tightening in Europe reduced GDP growth by
10% compared to the US, the IIF says. In terms of GDP growth per
capita, the difference was 5%.

Trend growth in the US was double that of Europe following the
financial crisis, the IIF says, whereas prior to 2008 they had
been the same.

Economic growth in Europe and the US was the same
before the 2008 crisis but Europe fell behind afterward. The data
suggests fiscal austerity was the difference.
IIF

Austerity hurts growth, in other words.

The main difference between Europe and the US in the post-crisis
period was that the US embarked on an era of robust government
spending in addition to a massive monetary stimulus
package from the US Federal Reserve.

The European Central Bank also adopted a monetary program of low
interest rates and quantitative easing (QE). But the European
Union continued to enforce its fiscal austerity program, banning
member governments from running deficits greater than 3% of GDP.
The EU also forced countries to pay down their debts during the
recovery. The most dramatic example of that was Greece, which
stayed inside the EU’s debt repayment program even though its
economy shrunk by 45%, peak to trough. Today, the EU is trying to
force Italy to keep its deficit below 1.8% of GDP, even though
the
Italian economy has stalled at 0% growth.

Two continents conducted an historic experiment in
macroeconomics, and the data is stark

The two continents thus conducted an historic experiment in
macroeconomic policy: The US went on a government spending
splurge while Europe tightened its purse strings.

The IIF’s data is stark. Europe is now poorer than the US, in
growth terms, because of austerity, according to Managing
Director & Chief Economist Robin Brooks and Senior Research
Analyst Greg Basile.

“What I find fascinating is that trend growth in the US and the
eurozone was basically the same,” Brooks told Business Insider.
“Leading up to the global financial crisis, they were both
growing around 2%. And afterwards you have this big divergence.”

“It’s not like Europeans are fundamentally lazier than Americans
in the last 10 years”

“So to me, that says it’s not like Europeans are fundamentally
lazier than Americans in the last 10 years. It’s just that
[economic] policy hasn’t been as supportive.”

Brooks and Basile discovered the gap while researching the IMF’s
data on potential GDP output gaps. Put simply, economists like to
compare current economic growth with a measure of “potential”
economic growth in order to test whether an economy is
functioning at its peak capacity or not.

They noticed an anomaly in the data that was particularly
dramatic in a comparison of Italy and Australia. Australia,
famously, has not had a recession since 1991 and escaped the
great financial crisis relatively unscathed. Cumulatively it has
added 30 percentage points of GDP growth since 2008. Italy,
however, took a big hit in 2008 and has been mired in a debt
crisis ever since. Its economy contracted by 4% since 2008. Yet
according to the IMF data, both countries only had output gaps of
just under zero, suggesting that both countries are functioning
at near-full capacity. Brooks and Basile’s research says.

Read more:

Europe is faltering

On its face, that’s weird: Australia’s economy ought to be
busting at the seams. And stagnant Italy ought to have plenty of
unused economic “slack” sitting on the sidelines. But
statistically, they are the same (in terms of how far they are
from fulfilling their potential).

“It’s just a completely counterintutive result, where the
definition of the output gap runs counter to any economic common
sense, basically,” Brooks says. It’s a similar picture for Spain
and Greece. It’s “devoid of economic intuition.”

If the IIF is right, then the ECB might be about to make an
historic mistake

The poor performance of Europe vs America is further disguised by
Europe’s current account surplus. The surplus is the excess of
exports Europe produces compared to imports. A surplus suggests
Europe is selling more things to foreigners than it is buying
from them. Economists usually regard this as a sign of health.
Germany’s historic manufacturing strength is the usual
explanation for Europe’s rosy export surplus.

But Brooks and Basile say Europe’s glass is actually only half
full. There’s a trade surplus because domestic demand outside
Germany is so weak, lowering imports. If you factor in a more
realistic output gap, then Europe’s current account would be in
deficit, they say.

The trade stuff is highly technical, to be sure. But if the IIF
is right, then the ECB might be about to make an historic
mistake. It is currently in the process of “normalizing” its
monetary policy, by bringing QE to an end and raising interest
rates. Brooks and Basile argue that the trade data and the
mismeasured output gap show that eurozone economic activity is
much weaker than the bank presumes, and deflationary pressure is
much stronger. Conditions suggest the ECB needs to continue to
help the economy with loose monetary policy, not end it; and the
euro is overvalued vs the dollar, and thus ought not to be
strengthened via tighter monetary policy.

Read more:
Britain enters the ‘Greek fallacy’ phase of Brexit

Solid data show that austerity in response to a recession makes
both countries and people poorer

For ordinary people, the bottom line is that there is now solid
data to show that austerity in response to a recession makes both
countries and people poorer than they need to be.

This also helps explain why many European countries continue to
have persistently high unemployment rates — Italy’s is more than
double the US or the UK — even though the stats say the output
gap is small, the IIF’s data suggests.

Persistent unemployment also generates a phenomenon called
“hysteresis.” It means that when people are out of work for a
long time, they lose the skills they need to rejoin the
workforce. The economy is then prevented from growing faster when
conditions improve because employers cannot find the workers they
need, even though there are plenty of people out of work.
Austerity inflicts damage on the total economy, in other words.

“I think the main message as I see it is, ECB normalisation is a
mistake,” Brooks says. “Fiscal austerity is a mistake.”