Why Austerity Is a Tough Pill to Swallow 

Kristina Hooper 

The Upshot 


The IMF’s call for countries to relax austerity measures has sparked renewed debate over whether spending cuts are an effective remedy, writes Kristina Hooper.

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Kristina Hooper, CFP®, CAIA, CIMA®, is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.

What hampers economic growth more, high debt levels or spending cuts?

That debate was reignited last week in the wake of the International Monetary Fund’s release of its world economic outlook. The IMF lowered its forecast for global growth in 2013 to 3.3% from 3.5%. It also cut growth estimates for the euro zone to -0.3% from -0.2%.

Helping drive the downward revisions is the IMF’s view that developed countries’ use of austerity to reduce debt will hamper growth. In fact, the IMF called on developed countries such as the United States and the United Kingdom to dial down their austerity plans in the near term to boost economic growth prospects. The plea for less aggressive measures has some market observers wondering whether one of the possible cures for massive debt—austerity—is worse than the disease.

Academic Debate

Many developed countries have excessive public-debt overhangs, and a number of economists believe that high levels of debt impede economic growth. Carmen Reinhart and Kenneth Rogoff’s seminal paper “Growth in a Time of Debt” is often cited as evidence that when public debt becomes excessive (higher than a 90% debt-to-GDP ratio) economic growth falls substantially. However, that paper came under fire last week by a Ph.D. student and his two professors at the University of Massachusetts who argued that some calculations were flawed, rendering an inflated picture of its impact on growth.

But Reinhart and Rogoff argue that the since-corrected numbers still show lower economic growth when debt rises above 90% of GDP. It’s important to note that Reinhart and Rogoff never established a causal connection between high public debt and slower economic growth; for example, some economists posit that this is a “chicken or egg” debate. High debt could result in slower economic growth or slower economic growth could result in high public debt, or both. It’s a vicious circle.

The scrutiny of Reinhart and Rogoff’s research follows the release of a working paper earlier this year by the IMF that argued that fiscal multipliers are often underestimated. The paper cites research suggesting that fiscal multipliers associated with government spending can fluctuate from being near flat in normal times to about 2.5 during recessions. So economies operating with a lot of slack—including many developed countries right now—could benefit the most from stimulus and arguably are particularly vulnerable to spending cuts.

This concern about austerity has been echoed by other sources recently. Last week’s release of the Federal Reserve Beige Book survey captured the view from some retailers that “the end of the payroll tax credit was having an increasingly negative effect on retail sales.” This observation is borne out in the recent downward revisions to January and February retail sales numbers as well as March retail sales weakness. Meanwhile, defense contractors have expressed worries over the impact of budget cuts: "San Francisco District defense-related manufactures noted furloughs, layoffs, and plant closures at some production facilities, and military customers in the Chicago District were taking measures to lower costs in anticipation of tighter future defense budgets.” Further, the Conference Board noted in its most recent Index of Leading Economic Indicators release that public-sector spending cuts were acting as “headwinds” to the economy, which is expected to grow only slowly. And austerity is clearly unpopular in Europe, where recent elections have shown popular distaste with the cuts.

Country Result
Feb. 13: Political gridlock - no party wins enough votes to form a government. Both anti-austerity candidates, Silvio Berlusconi and Beppe Grillo, win significant portions of the popular vote.
June 12: After several inconclusive elections, voters return to narrowly elect a coalition government that carries out austerity measures. However, parties that opposed the ECB bail-out and pro-austerity measures garnered over 46% of the popular vote.
May 12: Francois Hollande wins the French presidency, beating incumbent and pro-austerity candidate Nicolas Sarkozy. Hollande's platform was pro-growth with less emphasis on austerity.
April 12: Dutch Prime Minister advocates cuts to popular spending programs as part of austerity plans to bring the country into compliance with the EU’s deficit cap. The Freedom Party withdraws support for the prime minister’s minority coalition, and the government collapses. 

Stealth Tax

So what’s a public-debt-bloated government to do? The tool of choice for deleveraging is increasingly becoming financial repression because it serves as a “stealth tax.” What that means is it doesn’t have to be voted on because it’s largely carried out by central banks and most people don’t even realize it’s happening—until it’s too late. However, historically, it has proved effective in eroding public debt. With austerity becoming less and less politically palatable, it is likely that more countries will rely on financial repression to cure their ills.

Still, financial repression in the form of unconventional monetary policy is no panacea. Many economists believe that “easy money” policies are ineffective in creating significant growth and lowering unemployment. New Zealand central bank chief Donald Brash argued that monetary policy is not capable of impacting unemployment in a paper he wrote and a speech he delivered at Jackson Hole nearly 20 years ago entitled “The Role of Monetary Policy: Where Does Unemployment Fit In?” Other experts argue that monetary policy, while powerful, is currently impotent because many consumers and small businesses in the euro zone and the United States do not have access to lower borrowing costs because of a blocked bank-lending system. While steps have been taken to address this obstacle, the situation has not yet changed significantly. And the IMF also warned last week about many countries’ overreliance on monetary policy to drive growth, as well as the difficulty of exiting large-scale quantitative easing programs.

But, at least for now, it looks like governments will rely on financial repression. That means investors need to redefine what risk means to them. A recent UBS wealth-management survey showed that 41% of investors polled see risk as a permanent loss of portfolio value (presumably in nominal terms.) Only 15% of participants think of risk as not being able to meet their financial goals. In the face of financial repression, investors must get more goal-oriented. Why? Governments seeking to shrink their bloated debt levels through monetary policy will also be shrinking savings at the same time. Financial repression is here to stay. It’s time to rethink risk—and your asset allocations.

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The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

Gross domestic product (GDP) is the value of all final goods and services produced in a specific country. It is the broadest measure of economic activity and the principal indicator of economic performance.

Unless otherwise noted, index returns reflect the reinvestment of income dividends and capital gains, if any, but do not reflect fees, brokerage commissions or other expenses of investing. It is not possible to invest directly in an index.

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