The Problem with Europe’s Austerity Debate

Anders ÅslundSenior Fellow

Cato InstituteJune 5, 2013 1

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What Is Austerity?• Fiscal responsibility! = Money is not

free

• The real questions:

1. Fiscal responsibility: Now or later?

2. Who is prepared to pay?

3. To frontload or backload?3

Six Reasons why early fiscal adjustment preferable

1.1. Early return to growthEarly return to growth2.2. Politically easierPolitically easier3.3. Better fiscal adjustment Better fiscal adjustment 4.4. More structural reformMore structural reform5.5. Financial sustainabilityFinancial sustainability6.6. Earlier restoration of confidence Earlier restoration of confidence

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1. Early Return to Growth & Higher Growth Trajectory

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2. Politically EasierRahm Emmanuel: “A crisis is a terrible thing to waste.”•Latvia: One riot in January 2009. PM Valdis Dombrovskis – reelected twice & longest serving PM in Latvia: “In this situation we have only two alternatives – one bad and a worse one. I prefer the bad one.”•Greece: years of riots, strikes & demonstrations; radicalization of electorate; is democracy in danger?

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3. Better Fiscal Adjustment: Get ahead of the curve!

• Latvia 2/3 expenditure cuts, 1/3 tax hikes

• Greece: Little decline in public expenditures, lingering around 54% of GDP – GDP falls faster than expenditure cuts…

• Greece: Little prospect for growth 7

Latvia: Public Expenditure as % of GDP Normalizing

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Latvia Brought Down Budget Deficit, Greece Stuck at Huge Deficit

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4. More Structural ReformsExpenditure cuts drive growth

•Vested interest are not mobilized early on

•More deregulation

•More public sector reform – Latvia sacked 30% of civil servants instantly – Greece just starting

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Latvia: Sharply Falling Real Unit Labor Cost, 20%, 2008-12, Greece Less

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5. Financial Sustainability Vital

• Public debt in euro area on average Public debt in euro area on average 91% of GDP, end 201291% of GDP, end 2012

• Nine of 27 EU countries have lost Nine of 27 EU countries have lost market access and needed market access and needed assistanceassistance

• Financial assistance limitedFinancial assistance limited

• If no financing, little choiceIf no financing, little choice12

6. Confidence Restored Early• In Latvia bond yields peaked in June

2009 but in February 2012 in Greece

• Much lower yields and market interest rates in Latvia

• More domestic and foreign investment

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Greatest Mistake:Greece May 2010 Program

• Too large credits given caused default

• No structural reforms• No reduction of public expenditures as %GDP

• Too small fiscal adjustment• No confidence & no growth 14

Focus on Education!The key problem of Southern Europe:

•Little education

•Education of poor quality

Only 38% of the Portuguese labor force has graduated from high school (US: 88%)

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Share of Labor Force That Has Graduated from High School, 2012

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Performance on PISA Math Test, 2009

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Conclusions• Europe’s fiscally conservative north thrives:

Latvia’s GDP growth 5.5% in 2011 and 2012

• The backloaded South suffers: Meanwhile Greece GDP fell about 6% each year

• IMF advice seriously flawed

• Overestimated fiscal space in Spain, Cyprus & Slovenia

• Intentionally delays crisis resolution in the South 18