Imagine the outbreak of a common disease but as a new strain and on a scale not yet seen before. Symptoms vary depending on the patient which makes it difficult for even the best doctors across the world who are unsure of the cure. The patients are treated in different ways in different countries but nothing seems to be working. There does however seem to be a consensus that one form of treatment is causing unnecessary harm to the patients. This could be an analogy for the global economy with austerity being the treatment that has fallen out of favour. But, while the appetite for more painful government cuts may be on the wane among some policy makers, other policy options are limited.
The biggest sign of the shift in views was the head of the IMF, Christine Lagarde, making a call for austerity measures to be eased if growth continues to remain weak. The IMF is an international body which has funds to help bail countries out if their governments cannot get access to cash from elsewhere. The change in stance by the IMF has all the more meaning because the IMF itself has a reputation for imposing harsh measures on countries which require help such as in the Asian crisis in 1997.
The change in opinion follows new research which brought into question the effects of austerity measures. It was previously thought that austerity through cuts to government spending (or higher taxes) would reduce GDP by less than the actual measures themselves but the IMF research suggests that this may be too optimistic and such policies may reduce GDP by more than the amount the government benefits from austerity. This could create a downward spiral in the economy - lower government spending resulting in a bigger fall in GDP which in turns means that further government cuts are necessary to reach targets for budget deficits and so on.
The most interesting case with regard to austerity is the United Kingdom where the government has adopted austerity policies of their own volition while other countries in the midst of government spending cuts have been forced into such measures due to high interest rates on their government debt. The coalition government in the UK headed by the Conservative party has advocated the need to reign in government spending using the debt crisis in places like Greece and Spain as examples of what could happen otherwise and emphasizing the need to maintain a good credit rating as justification for cuts. Yet, the interest rate on government debt in the UK is near a record low which means that there is less of a need for urgency in dealing with the government budget deficit which is expected to be 5.5% of GDP in 2012 with government debt at 89% of GDP.
The rightward bent of the Conservatives means that the party has an ideological inclination toward wanting to reduce the size of government. The debt crisis in Europe has provided a useful tool for the Conservatives to convince voters that this is the right course of action. But Your Neighbourhood Economist would argue that fervour with regard to austerity in the UK is based more on right wing ideology of the government than on economic practicalities. And the repercussions of austerity on the economy have become evident in the change in stance by the IMF and a further 10 billion pounds in cuts which were announced by the Conservatives in early October.
The worst may not yet be over with the IMF becoming more pessimistic with regard to the outlook for the UK economy with a 0.4% fall in GDP predicted for 2012 compared to a 0.2% rise forecast in April. Growth of 1.1% is predicted for 2013 which is lower than the 1.4% estimate in April. A further deterioration in the economic outlook for the UK is a real possibility if austerity measures continue to do more hindrance than help.
Yet, while less austerity would help to ease the burden on many, it is more depressing to consider that a change in tact by the UK government may have only a minimal effect. The malaise of the UK economy is due to not only the government cuts but also a sluggish global economy and a high degree of uncertainty which limits the appetites of companies to invest. So the effects of measures implemented in individual countries may be limited unless there is a certain degree of coordination between governments in the larger economies. But this seemly unlikely – more on that in my next posting (but mostly bad news sorry).