Some sorts of austerity are better than others

Is there a better way to consolidate the public finances without damaging growth, both in the short term and the long term?

Economy|Foreign Affairs
Guest Writer | 08.06.2012

By John Springford

Governments in the eurozone’s periphery are pursuing a scorched earth fiscal strategy. Distressed governments may not be able to afford a fiscal stimulus or even a delayed consolidation, partly because of the size of their deficits and partly because they do not fully control the currency in which that debt is issued.

In the absence of transfers from the eurozone’s creditor nations, governments in the periphery are cutting every area of spending indiscriminately. Pro-growth investments in infrastructure and education are being slashed alongside consumption, like welfare payments. This is no way to build “competitiveness,” as Germany insists they must.

Public investment has a high “multiplier”– economics jargon for extra growth generated by government spending. Most economists calculate that the infrastructure spending multiplier is greater than one, which means that for every €1 spent, more than €1 of economic activity will accrue. Some studies put the figure as high as two.

The education spending multiplier is harder to calculate, but according to the OECD, people who complete university earn 11 percent more a year on average than those who only have secondary education. Those who finish high school earn 9 percent more than those who drop out. This suggests that government education spending provides a sizeable “bang for a buck” over time. The initial investment will be more than repaid through higher tax receipts and lower welfare spending.

In Spain, the state’s investment in infrastructure averaged 3.8 percent of GDP in the decade before the financial crisis. Over the last three years it has slashed this share to 2.8 percent – and the 2012 budget foresees this falling to just 1.8 percent. Advocates of austerity argue that the country already has excellent transport infrastructure (much of it linking up housing developments that are now moribund).

They are right that further transport infrastructure spending in Spain may do little to boost activity over the longer term, even if it provided a quick stimulus. But investment in education would. Half of Spain’s youth drop out of high school before 18, have fewer marketable skills, and so impose massive claims on the taxpayer in the form of unemployment benefits later in life. Yet Spain is cutting the federal education budget by a fifth this year.

This pattern is being repeated across the periphery. Portugal, Italy and Ireland have cut infrastructure spending by 0.4, 0.5 and 0.7 percent of GDP, respectively, over the past two years, and are planning to go further. Italy and Portugal are reducing educational expenditure at all levels; Ireland is making small cuts to the schools budget but larger ones to spending on higher education. Is there a better way to consolidate the public finances without damaging growth, both in the short term and the long term?

Is there a better way to consolidate the public finances without damaging growth, both in the short term and the long term? The UK’s Social Market Foundation, and the International Monetary Fund (IMF), have recently suggested that Britain use the “balanced budget multiplier,” and cut areas of spending with low multipliers and recycle the money into investment. The UK fell into recession in the first quarter of 2012, partly because the government had slashed investment, which led to a fall in construction spending.

Using the balanced budget multiplier ensures that austerity’s impact on short-term output is as small as possible, and helps to encourage growth in the long term, as investments encourage private sector activity. This approach could be applied in the eurozone periphery: while immediate austerity is impossible to avoid without more help from the core, the periphery should seek to cut back further on low-growth areas of spending and hold investment steady, or increase it for a clearly defined period of time.

But what areas of spending should they cut? The area of government activity that has the lowest multiplier is the incentives which governments provide to encourage people to save more. By offering tax relief on direct contributions to private pension and saving pots, government money gets funneled into consumption that will take place far in the future. This reduces demand in the short term, as government money that could be spent now is spent later.

Every government in the eurozone’s periphery makes pension contributions tax-free up to certain limits, and then taxes pension income when workers retire and their pot is drawn down. Governments could switch this around: contributions could be taxed, and pension income made tax free. Alternatively, they could lower the amount that people can save without being taxed.

Other areas with low multipliers, such as welfare payments to middle class households (like child benefits) could also be considered. The reason is that people on higher incomes tend to save more of their income, so cash transfers to them have a low multiplier. The cash saved could then be recycled into public investment, which boosts economic growth. Investors are unsure whether austerity is the only route out of the crisis, or whether it is self-defeating.

The measures outlined here would not, of themselves, be sufficient to spur a marked recovery in demand. But as an approach to austerity – which is probably unavoidable in the periphery to some degree, given the way the eurozone is currently configured – it would be far less damaging to growth than the current policy of indiscriminate cuts.

Such an approach should satisfy bond markets. Investors are unsure whether austerity is the only route out of the crisis, or whether it is self-defeating. If peripheral countries relax austerity, they risk investor flight and unaffordable bond yields, or they risk losing access to bail-out money from the Troika – the European Central Bank (ECB), European Commission and IMF. Germany obsesses about moral hazard and governance. But if the periphery’s governments demonstrate their political will to cut transfers and government consumption, and commit themselves to holding public investment steady, they could be considered worthier beneficiaries of German aid.

John Springford is a research fellow at the Centre for European Reform (CER) think-tank in the United Kingdom, which first published this article here. 

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