More spending won’t rescue Europe’s six big spenders
FORTUNE — The leaders of distressed European nations, from Italy’s Mario Monti to France’s Francois Hollande, are blaming “austerity” for their economic woes, and championing policies that promote “growth.”
It’s important to define the two terms. Austerity stands for shrinking budget deficits, by lowering spending, raising taxes, or a combination of the two. The pro-growth measures are what’s known in the U.S. as “stimulus.” It comprises short-term fiscal policies designed to limit the damage from a recession and speed recovery. Stimulus works in precisely the opposite direction of austerity by raising budget deficits, supposedly as an emergency measure. Today, southern Europe’s heads-of-government, applauded by the Obama administration, advocate recharging their flagging economies by swelling the gap between revenues and expenses, chiefly by lifting government outlays.
This blueprint for revival has two glaring flaws. First, the ailing nations, except in rare instances, haven’t even attempted the deficit-slashing “austerity” that’s supposedly causing their decline. Second, these countries have been deploying enormous deficits since the recession began in late 2008, and yet this constant “stimulus” has done absolutely nothing to cushion the recession or hasten a recovery. Their principal legacy is saddling the weaker nations with unsustainable levels of debt, a situation that would become far worse if Europe heeds the current calls for more spending and deficits.
To gauge where these policies went wrong, we’ll examine the performance of what we’ll call Europe’s “Six Spenders:” France, Italy, Spain, Ireland, Greece, and Portugal. To simplify, we’ll treat the Six Spenders as if they were one big country by combining their deficit, spending, debt, GDP growth and other numbers.
The big push for stimulus began in 2009. From the end of 2008 to 2011, the Six Spenders had combined budget deficits of almost $1.4 trillion (we’ll translate all euro numbers into dollars). That’s approximately $450 billion a year, or an enormous 7.3% of GDP. So how much growth did all that “stimulus” create? Over those three years, the Six Spenders’ combined output shrank by 5%, adjusted for inflation.
Public sector spending stayed steady in real terms, even though tax revenues fell sharply — hence the big jump in deficits. So why did the economies overall perform so poorly? GDP has four components: government expenditures, consumer spending, private or business investment, and the surplus of exports over imports, or vice versa. The rationale sustaining government spending in a recession is that it sustains not just that category, but also boosts the other three, so that the economy expands far faster, or shrinks a lot less, than it would without the stimulus. For example, hiring more public transit workers and raising unemployment payments would lift “aggregate demand” as consumers spend their government paychecks and federal benefits on restaurants, cell phones, and condos.
It didn’t happen. While governments held their spending at already elevated levels, the private sector shrank drastically, explaining that fall in total output. From 2008 to 2011, the sum of private investment, net exports and consumer spending dropped almost 10% in inflation-adjusted euros. That fall of $140 billion is almost exactly the same as the increase in combined deficits over the same three years. It’s hard to avoid the conclusion that stimulus designed to boost growth simply moves the same money around, with no immediate effect on growth.
Here’s why stimulus doesn’t work. The extra money needed to support ever-increasing deficits must be borrowed. A large portion of those borrowings flow from the nations’ citizens. Instead of buying newly issued stocks or bonds, or placing cash in savings accounts where the euros are loaned to businesses, Italians or Greeks purchase government securities. Money that used to flow to private investment is now going to the government. Rather than being spent on robots, computers and other capital equipment, it’s now channeled to newly-hired government workers, who spend it on cars or vacations, or to more generous unemployment benefits.
In the short-term, whether the euros go to private investment or government spending has a minimal effect on growth. Once again, it’s the same money just changing categories. But over several years, shifting productivity-enhancing investment to government spending slows growth.
In fact, the Six Spenders’ poor performance in the recession is an outgrowth of the heavy spending policies they pursued in the preceding years. From 2004 to 2008, the governments used the tax windfall from a boom in consumption and real estate bubbles, both courtesy of low, German-style interest rates, to substantially raise government spending as a share of the economy. At the same time, the private sector shrank, going from 62% of GDP to 58.5% in Spain, 54.7% to 52.5% in Greece, 52.5% to 51.3% in Italy, and 66% to 57.2% in Ireland. (Those numbers are now even lower because of the recession.)
How about the argument that growth would have been even worse without the support of big deficits? And how do we know that the shrinking private sector is what made these nations so vulnerable, and perform so badly, in the recession? Fortunately, the Eurozone provides the equivalent of a “control group,” for this experiment. It’s the largest Eurozone economy, Germany. From 2008 to 2011, Germany did relatively little deficit spending, and thus deployed minimal stimulus. Yet it managed to actually increase GDP by 1% in total over that three-year period, versus a 5% drop for the Six Spenders.
Once again, it was the growth of the private sector in the years before the recession that explains Germany’s resilience. From 2004 to 2008, the private economy expanded from 53% to 56% of GDP, and government spending was highly restrained. That freed more money for companies to invest in plants and research facilities, creating a dynamism that served Germany well in the recession, while the Six Spenders were channeling more resources to the government.
It’s important to realize that, in theory, Keynesian “stimulus” only works if the deficit this year is bigger than the one last year. Keeping a huge deficit constant, or shrinking it slightly, will not provide the jolt the growth crowd wants. Hence, spending by the Six Spenders for 2012 would have to far exceed the combined $370 billion shortfall for 2011.
But the string of big deficits has already saddled those countries with heavy debt. Their average debt-to-GDP ratio is now 93%, versus 65% in 2004. Ireland, Italy, Portugal, and Greece are all at 108% or more. A $500 billion deficit in 2012 would inflate that ratio by more than eight more percentage points.
It’s difficult to understand how the heads-of-government think that their nations can actually run even bigger deficits that will pile on even more debt. The markets are already turning against them — witness the gigantic spread between rates on German and Spanish government bonds, with the latter approaching a disastrous 7%.
“The markets will not allow these countries to continue borrowing on this scale,” says Uri Dadush, an economist at the Carnegie Endowment. “Deficit reduction is an essential element to getting them to grow again. The size of their government sectors is proving unsustainable.”
It’s become a widely accepted cliché that “stimulus” and big deficits equal growth. That’s an illusion supporting policies that are pure delusion.