The Pain of Austerity

If you've been awake over the past few months, you're aware that the world, particularly Europe, is suffering from a rather uncomfortable debt situation.  As I posted here, it is going to be an uphill battle for the world's advanced economies to reduce their rapidly growing debt levels; the Bank for International Settlements (BIS) recently stated that to bring government debt-to-GDP ratios back to Great Recession levels, it will take 20 consecutive years of surpluses exceeding 2 percent of GDP!  The odds of that - slim at best and most likely nil.

Earlier this year, the Congressional Budget Office released an interesting paper entitled "Sovereign Debt in Advanced Economies: Overview and Issues for Congress" by Rebecca Nelson.  In this paper, Ms. Nelson notes that the high levels of debt among the world's advanced economies are a new global concern that has erupted out of the 2008 - 2009 global financial crisis.  As we have seen, governments are embarking on fiscal austerity programs in a last ditch effort to get their books in order, however, some economists note that these measures may well undermine the very weak global economic recovery, now into its third year.  As one would expect from a non-science science, other economists argue that current government austerity measures do not go far enough to rein in burgeoning debt loads, particularly as most developed nations will be experiencing top-heavy population trees.

How does all of this fit into the mandate of Congress?  There are two factors to consider:

1.) Is it likely that the U.S. is headed for a Eurozone-type debt crisis?  Current bond interest rates would suggest that this is unlikely, however, looking back five years, one would have never suspected that the PIIGS sovereign bonds would be suffering from interest rates in excess of 6 percent.

2.) What impact will Europe's debt crisis have on the United States economy?  Slower growth in advancing economies could impact trade between America and its main trading partners.  As well, in September 2011, direct U.S. bank exposure to Greece, Ireland and Portugal reached $55 billion, leaving their balance sheets somewhat vulnerable.

Let's start by looking at several graphs from the report.  The first graph shows the changes in the gross public debt levels for the G-8 nations since the end of World War II:

The sovereign debt level for the G-7 rose from 84 percent of GDP in 2006 to a forecasted 119 percent of GDP in 2011, a 42 percent increase in just five years.

The second graph shows the gross government debt for both advanced economies and developing economies between the year 2000 and 2010, projected forward to 2016:

Sovereign debt levels for the G-7 economies rose from 84 percent of GDP prior to the Great Recession to 114 percent of GDP in 2010 and are projected to rise to 127 percent of GDP by 2016, an increase of 51 percent over 10 years.  In sharp contrast, debt levels in developing economies fell from 52 percent of GDP in 2002 to 39 percent of GDP in 2010 and are projected to fall even further to 29 percent of GDP by 2016, a decrease of 44 percent over 14 years.

Here is a graph showing the variation of gross public debt among advanced economies in 2011:

Here is a graph showing the variation of net public debt among advanced economies in 2011:

Please keep in mind that the difference between gross and net public debt statistics refer to that particular government's financial assets which are subtracted from gross public debt to give us net public debt.  In the case of Japan, its gross public debt in 2010 was 220 percent of GDP but, thanks to large assets, its net public debt is "only" 117 percent of GDP.  In sharp contrast, Greece's gross government debt and net government debt were both 143 percent of GDP in 2010 since the Greek government has no assets.

What kind of measures would be required to get this debt problem straightened out?  Here is a graph showing the fiscal cuts that would be necessary to reduce debt levels to 60 percent of GDP by 2030 for the world's advanced economies:

To help you understand the preceding graph, let's look at the United States.  Please note that a primary budget surplus is the budget balance excluding interest owing on the debt.  The U.S. would have to achieve a primary surplus of 5.1 percent of GDP by 2020 and sustain it through to 2030 to achieve the 60 percent debt-to-GDP goal.  In 2010, the primary deficit was 8.9 percent of GDP.  This means that the total fiscal cuts necessary for the United States to achieve the 60 percent debt-to-GDP goal would be equal to 11.3 percent of GDP relative to the 2010 primary balance (deficit) or just under $1.7 trillion, the third highest among advanced economies after Japan and Ireland and just ahead of Greece.  Now that's painful austerity!

On average, the world's advanced economies would have to reach a primary budget surplus of 3.8 percent of GDP by 2020 and sustain it through to 2030 to achieve the average 60 percent ratio.  Currently, the advanced economies are running a primary budget deficit of 4.8 percent of GDP meaning that, to reach the target of 3.8 percent surplus by 2020, the average fiscal adjustment will have to be 7.8 percent of GDP.

With this data in mind, why does the United States seem exempt from the wrath of the world’s debt market?  The saving grace that is currently preventing the United States from becoming the next Greece, Portugal or Ireland is the fact that its currency is the world's choice for its reserves.  As well, generally strong economic growth has kept the debt wolves at bay.  That said, here is a graph showing how quickly Spain saw the yield on its 10 year bond rise from under 4 percent to just over 7 percent:

Basically, we cannot say that the interest rates on U.S. federal debt will never rise rapidly.  At some point, the world's bond traders may simply lose confidence in the ability of the American government to continuously grow its debt, particularly if there is a repeat performance from Congress over the debt ceiling.

To summarize, the solution to the world's sovereign debt issues look rather daunting.  As we've seen in Europe, the imposition of what have been until this point relatively modest austerity measures have resulted in both social upheaval and the tossing out of incumbent governments.  The world's economy is already showing signs of slipping back into negative growth even with the very modest measures taken.  There is one thing that I think we can count on; the next recession will be different than the recession that the world experienced in 2008 - 2009.  Since sovereign debt levels were not at the sky-high levels that we are seeing today prior to the Great Recession, we are entering uncharted fiscal territory.  The next global downturn could well be "The Big One".

The Unmitigated Failure of European "Austerity"

Michael D. Tanner of the CATO Institute recently published an article entitled "Europe's Failed Austerity" discussing the recent election results in Europe as they relate to the public's backlash against austerity programs.  He notes that many American advocates of "bigger is better government" use the apparent failure of European austerity measures as an example of why Washington must make a sharp U-turn, reversing its very modest attempts at fiscal balance.  This seems to be of particular importance to these advocates because they draw the conclusion that Europe's very modest recent economic growth is directly related to cuts in government spending.  This recent GDP data release from Eurostat would appear to bear up that argument:

Outside of the former Iron Curtain countries of Slovakia, Estonia, Latvia and Lithuania plus Finland, the United States' Q1 2012 GDP modest growth rate of 2.1 percent looks stellar when compared to most of the rest of Europe where the average economic growth rate is a barely perceptible (and easily correctable in a downward direction) 0.1 percent for all 27 nations.  Apparently, these big government advocates would suggest that it is Europe's cut and slash ways that have triggered a near-continentwide recession; this logic would suggest that America should continue along its "stimulate by spending more than it brings in" philosophy to keep the Union out of recession.

On average, Europe's government spending contributes more than half of GDP.  Government spending appears to still be at roughly the same level despite so-called austerity.  Rather than cutting spending, nations have elected to raise taxes, a measure that according to some economists is likely to have the exact opposite impact on debt than anticipated.  Here is a breakdown of the austerity measures for both France and the United Kingdom:

1.) France has raised taxes by imposing a 3 percent surtax on incomes above €500,000 accompanied by a one perentage point increase in the top marginal tax rate, raising it from 40 to 41 percent.  France also increased corporate taxes by 5 percent on businesses with more than €250 million in revenue and closed some corporate tax loopholes.  This was topped off with an increase in VAT from 19.6 percent to 21.2 percent.   All of this was implemented to keep the budget deficit for 2012 to 4.5 percent of GDP which is still above the 3 percent European Union target.  By the end of February 2012, the budget deficit had narrowed by 13.5 percent on a year-over-year basis, however, year-over-year spending was up from €57 billion to €63.56 billion.  Fortunately, revenues were up 13.5 percent to €43.2 billion.  Despite France's best-laid plans, the budget deficit hit 5.2 percent of GDP.

2.) The coalition government in the United Kingdom has hiked personal income taxes for those earning more than £150,000 to 50 percent.  According to Mr. Tanner, that move actually managed to decrease income tax revenues by £509 million.  Oops!  While the U.K. government did trim payrolls and programs, British government spending consumes more than 49 percent of GDP and has risen by £59.2 billion from 2009 to 2011.  Again, oops!

This seems to be the pattern throughout the Eurozone.  Raise taxes on the wealthy and promise that you'll cut spending at some distant and poorly defined point in the future.  In addition, governments in the Eurozone have decided that raising the level of the Value Added Tax "licence to print money" is the best option to achieve a semblance of fiscal responsibility.  As shown on this chart, here's how many Member States and other jurisdictions are adopting this practice:

Never let it be said that there's an original thinker among our leadership.

How lucrative is the VAT machine?  Looking at the case of Germany, government's receipts from VAT totalled 36.6 percent of all revenue compared to only 21.4 percent from income taxes on wages.  To simplify things, the more Germans spend, the more the government makes.  In my opinion, this certainly is not a sustainable situation particularly if a continent-wide or global recession takes hold.

While the topic of a Value Added Tax (VAT) has been on the back burner since it reappeared in early April 2010 after a comment by Paul Volcker, the imposition of a consumption tax is not likely off the table over the long-term, particularly since the U.S. is the only OECD nation without a national sales tax.  With four deficits in a row in excess of $1 trillion, Washington desperately needs a "money machine" since apparently, it has not seriously crossed the minds of those in Congress to cut spending.  With a debt of $15.7 trillion, Washington will be looking for any source of revenue that it can get its hands on.  It's going to be a case of "monkey see, monkey do" for cash-starved Washington.

To put this tax into perspective, here is a chart showing current VAT rates across Europe:

Washington will be hard-pressed not to engage the services of this particular cash cow and what better time to do it than when a President is in his second term with no need to try for re-election.  From personal experience, living in a jurisdiction that is about to implement a similar tax, governments will do whatever they can to assure voters that these regressive forms of tax are anything but regressive and that you will actually be financially better off under the new regime.

I summary, looking back at Europe, we see governments grabbing for cash using creative tax measures at the same time as they are making very modest attempts at spending restraint.  Could these very unpopular moves be why voters in France and Greece couldn't wait to turf their governments in recent elections?  Perhaps the electorate in other European nations will follow suit as they tire of watching their governments grossly mismanage their fiscal responsibilities.

Moving to the western shores of the Atlantic Ocean, perhaps Americans will adopt the same modus operandi in November 2012.  Maybe we're all just a wee bit tired of the same old nonsense from those that we elect to "lead" us.

Austerity in Europe - Is It Accomplishing Anything?

In recent days, weeks and months, those of us who live in the overly-indebted so-called "developed" world have been subjected to repeated attempts by governments to cut spending in a last gasp effort to achieve some semblance of fiscal balance.  Those of us who live in Canada and the United States are well aware that the feeble efforts of our elected elitists are pretty well pointless; to make the expenditure cuts and tax increases necessary to balance budgets would be a surefire guarantee of losing in the next election cycle.

With all of the hubbub about Europe's debt dilemma over the past 18 months and, in particular, the talk of austerity among the most uncomfortably indebted nations, how deep have the spending cuts really been?  Fortunately, one of my favourite economists, Veronique de Rugy, a Senior Research Fellow at the Mercatus Centre at George Mason University in Virginia has answered the question for us.  How hard are European leaders really trying to achieve fiscal balance and reduce their debt and deficit load?

Ms. de Rugy's research shows that, while it appears that the results of recent elections in both Greece and Spain suggest that the citizens of these countries turfed their incumbent governments because of severe cuts in spending, that is not the case.  Apparently, austerity in Europe does not mean cuts in spending rather, the size of spending cuts were tiny compared to increases in taxes.  Ms. de Rugy notes that spending cuts are the most important form of austerity.  Increases in taxes, while helping to increase revenue, actually do not successfully reduce debt-to-GDP ratios.  As well, tax increases usually have a negative impact on the guilty nation's economy.

Ms. de Rugy looks at five nations in particular; Italy, Spain, France, the United Kingdom and Greece and examines their spending habits over the past decade.  Remember, these four nations are among those that supposedly have implemented the greatest austerity measures.  Here is a graph showing the spending habits of all five aforementioned nations between 2002 and 2011:

Quite clearly, United Kingdom and France have not cut spending as shown on these two graphs:

Spending cuts in Greece, Italy and Spain were actually very small when compared to the size of their budgets as shown on these two graphs for Spain and Italy:

Italy's expenditures in 2010 were only 0.75 percent lower than in 2009 and were actually 2.2 percent higher than in 2008.  Spain's expenditures in 2010 were 1 percent lower than in 2009 and were 6.4 percent higher than in 2008.  That's some austerity!

As shown on this graph, even using total government spending in constant 2009 U.S. dollars, only three of the nations, the United Kingdom, Italy and Greece, show very marginal drops in spending since the inception of the Great Recession when everything seemed to go off the rails for Europe's debtor nations:

In her conclusion, Ms. de Rugy notes that those European nations that did impose spending cuts, accompanied those cuts with larger tax increases.  Here is her analysis of that approach:

"This so-called balanced approach - some spending cuts for large tax increases - has been proven to be a recipe for disaster by economists.  It fails to stabilize the debt, and is more likely to cause economic contractions."

Recent economic data from Europe showing an overall contraction in some of Europe's strongest economies may be proving Ms. de Rugy's hypothesis.  An even moderate period of negative economic growth is about the last thing that Europe needs right now.  Perhaps our North American leaders could learn from Europe's example; showing some restraint on overspending now and resisting the temptation to overdo it on the taxation side of the ledger may be more important than they think.

Austerity and Anarchy: Is There A Relationship?

Updated February 2013

Recent news coverage from Europe has shown us just how unpopular government austerity measures are among the "sweaty masses".  People tend to express anger when the ruling class imposes cuts on entitlements, particularly when those cuts have been necessitated by economic mismanagement by the very people that are imposing austerity.  A Discussion Paper entitled "Austerity and Anarchy: Budget Cuts and Social Unrest in Europe, 1919 - 2009" by Jacopo Ponticelli and Hans-Joachim Voth provides an interesting look at the historical relationship between social instability and violence as it relates to government austerity.  This interesting paper could well provide us with a look at how North American societies could deal with painful cuts in government spending.

The authors open by noting that social unrest has been a key issue in history, particularly since the French Revolution.  Social unrest is a powerful mechanism for political change; one need look no further than the Arab Spring to see how powerful the public is when acting in concert against government.

The authors focus on a European database from 1919 to 2009 as the continent underwent changes from high levels of instability and low levels of prosperity in the first half, changing to become a very stable and prosperous society in the second half.  Social unrest includes rioting, demonstrations, assassinations, government crises and attempted revolutions.  The data is then compiled into an index that summarizes all aspects of social unrest which the authors term CHAOS and then compared to cuts in government spending in an attempt to answer the question - for every percentage cut in government spending, how much social instability should we expect?

Here is a graph showing the CHAOS or number of social unrest incidents over each year of the study:

In light of the current debt problems faced by Italy, it is interesting to note that in the 90 year sample, Italy had the highest number of incidents at 38 in 1947 alone including 7 general strikes, 19 riots and 9 anti-government demonstrations.  The period between the two World Wars showed relatively high levels of unrest and the period immediately after World War II and between the years of 1968 and 1994 showed unusually high levels of unrest with several years showing 30 or more events in a single year.

Here is a chart showing the causes of unrest in the period between 1980 and 1995, how many events there were related to each cause and the average number of protestors per event along with the numbers arrested:

In the 15 year sample, there were relatively few protests related to the imposition of austerity measures, however, these protests tended to be far larger by an order of magnitude when compared to protests related to other causes.

The data shows a very clear correlation between the size of austerity measures taken as a percentage of GDP and the degree of social unrest.  CHAOS, or the sum of all actions of social unrest in each country in a given year, tends to rise as budget cuts rise as shown in this graph:

As I noted above, please remember that this is real data taken from 90 years of European history.  When government expenditures are increasing (white bars), CHAOS registers less than 1.5 events per year.  When government expenditures are reduced by 2 percent of GDP, CHAOS rises to 2.4 events per year and, when government expenditures are reduced by 5 percent or more, CHAOS rises to more than three events per year per country.

On the graph, you can also see a rise in each component of CHAOS as governments enact more stringent austerity measures; the frequency of strikes, assassinations, riots and demonstrations increases as governments cut spending as a percentage of GDP.

The authors conclude that governments may be reluctant to impose austerity measures on their electorate until it is too late because of governments fear societal instability and unrest.  Cutting expenditures significantly increases the frequency of anti-government demonstrations, general strikes and attempts to overthrow the existing government order.  Another study has also shown that more heavily indebted nations tend to have higher levels of social unrest, a factor that is most certainly working against Greece and will not likely work in the favour of Italy should history repeat itself.