International Relations and Security Network, September 9, 2010
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If there were ever a time where the basic Keynesian logic held true it is now. Demand from the private sector has plummeted as a result of the housing bubble's collapse in the UK, Spain, Ireland and elsewhere. This has put an end to a construction and consumption boom that propelled the bubble economies directly, and indirectly drove economies like Germany’s through the creation of rapidly growing export markets. The collapse of these bubbles eliminated an amount of demand that was between five and 10 percentage points of GDP, depending on the country.
There is no easy way that this much demand can be replaced quickly from the private sector. Consumption will remain depressed because of trillions of dollars of lost wealth. The plunge in housing prices destroyed the savings of tens of millions of homeowners in the bubble countries. There is no mechanism that will prompt these people to go out and spend given the enormous loss of wealth they have experienced.
Similarly, the enormous overbuilding resulting from the bubble is going to leave the construction sector across much of Europe depressed for most of the next decade. There will be very little demand for additional housing. In many areas there has also been overbuilding in the non-residential sector, ensuring that it too will be a drag on growth as well.
In this context, government is the only obvious source of demand that can fill the gap. It was important that the governments of Europe quickly shifted to running large deficits. This limited the damage caused by the downturn. However, with governments starting to reduce spending and raise taxes, the governmental sector will soon be a drag on growth as well.
Toward fiscal contraction
The move toward fiscal contraction is likely to be an even bigger problem in European economies than it would be in the US, since the governmental sector (directly or indirectly) accounts for more than 50 percent of Europe’s output compared to less than 40 percent in the US. This means that the private sector must achieve considerably more growth to offset a fiscal contraction of the same size.
Given the heavy debt burden of households, the proponents of fiscal contraction must rely on improvements in net exports and investment to provide the offsetting boost to the economy. As a number of recent studies have shown, there are examples of countries that have achieved solid growth following a path of fiscal contraction. However, in most of these cases, a large boost in net exports played a key role. The countries generally saw a fall in interest rates and an accompanying decline in their currency’s value, which made their products considerably more competitive. In periods where trading partners were growing rapidly, this could provide a basis for export-led growth.
However, this will be much more difficult in a context where the whole world is still dealing with the fallout from the crisis. Certainly within Europe, the effort to increase exports will be a zero-sum game. If Germany manages to increase its exports to Spain, Portugal and Greece, then it will only worsen the downturn in these countries.
There is some hope that Europe as a whole can increase its exports to the rest of the world, but this will provide a limited basis for recovery. The crisis-induced plunge of the euro, coupled with more rapid growth in the US, did cause Europe’s trade surplus with the US to increase substantially in the most recent quarter. However, US growth is almost certain to slow, and the euro has regained much of its lost value now that the immediate financial crisis facing the weaker countries has eased.
The rise in the euro’s value will weaken its competitive position against all its trading partners, not just the US. Europe will be able to improve its trade position with rapidly growing countries like China, India, and Brazil, but its exports to these countries are simply not large enough to provide a sufficient boost to offset a fiscal contraction of the size being planned.
The other mechanism through which fiscal contraction can foster growth is through the effect of lower interest rates on investment. However, this prospect also offers very limited promise. In the largest economies – Germany, France, the UK and Italy – interest rates were already quite low. There seems little prospect that interest rates will fall substantially from current levels. Furthermore, given the enormous degrees of excess capacity in most sectors, lower interest rates are unlikely to provide much stimulus to investment.
There is a more plausible story of fiscal contraction boosting investment in the crisis countries, but this is only in the context of the soaring interest rates experienced before the rescue package was put in place. In other words, these countries are likely to see more investment with a rescue package that requires substantial reductions in budget deficits than if their finances remained in crisis, but they will not see more investment than if they had gotten a rescue package and had not imposed fiscal austerity. The rescue package simply brought investment back to its pre-crisis path, which was nowhere near strong enough to bring these economies back to potential GDP.
It would have been far more expansionary for the European Central Bank (ECB) to commit itself to support these economies without any near-term requirement for fiscal austerity. Given the severity of the downturn and the enormity of the deflationary pressures across Europe, there is no reason that the ECB could not simply buy and hold large amounts of debt of member states. Japan’s central bank has been doing this since the middle of the 90s, and it remains plagued by deflation, not inflation.
There could have been longer-term conditions imposed to ensure that countries on genuinely unsustainable paths, like Greece, get their finances in order. It is worth remembering that in the case of several countries, like Spain and Ireland, the fiscal crisis is the result of the downturn. Their debt to GDP ratios had been low and falling prior to the economic collapse.
The economic path that Europe is following is likely to leave the continent mired in stagnation for much of the decade. The only plausible source of substantial growth in demand is increased exports to rapidly growing developing countries. However, the base for this growth is relatively small, and there is no assurance that growth in these countries will be sustained, or at least not at its recent pace.
The work sharing solution
There is an aspect of Europe’s efforts to cope with the crisis that is very much worth noting. Several countries, most notably Germany and the Netherlands, have implemented a policy of work-sharing to offset the reduced demand for labor. In effect, this policy provides businesses with incentives to reduce the number of hours per worker rather than reduce the number of workers on the payroll.
Unemployment benefits are then paid to offset some of the reduction in hours, rather than to workers who are fully unemployed. This means that the net cost to the government is little different than the cost of traditional unemployment benefits. This route also has the benefit for the employer, such that when demand does increase, they already have workers on their payroll. Rather than seeking to hire new workers, they can simply increase the hours of the existing workforce.
Partly as a result of work sharing, unemployment in the Netherlands has risen by just 1.5 percentage points during the downturn to 4.3 percent. The current German unemployment rate of 7.0 percent is actually slightly lower than it had been at the start of the recession.
The success of these countries in using work sharing to shield their labor force from the effects of the downturn is truly remarkable. This policy allows reduced demand to be translated into more leisure time for workers who keep their jobs rather than unemployment for large numbers of workers who lose their jobs.
In this context, the prospect of prolonged European stagnation looks considerably less bleak, at least for the countries that are able to successfully implement work sharing. While it would be best not to waste potential output, leisure is valuable, and it is also likely that there will be fewer greenhouse gas emissions and other pollutants emitted at lower levels of output. Healthy growth would always be a first best option, but stagnation coupled with full employment policies is far better than stagnation coupled with double-digit unemployment.