Global Trends by Martin Khor

Monday 17 May 2010

From fiscal stimulus to austerity policies

For many countries that have over-borrowed to spend their way out of recession, the limits of fiscal stimulus have been reached, as Greece and other European countries have shown. 

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For the last two years, the priority concern of many countries was to counter recessionary forces that threatened to plunge their economies downwards, with potentially big job and income losses.

The new “orthodox” policy was to have fiscal stimulus packages (a boost to government spending) and easy monetary policies (low interest rates and increased liquidity to the banking system).

This new orthodoxy was opposite to the Washington Consensus, transmitted via the International Fund to developing countries in times of crises, which preached government budget cuts and high interest rates.

Through three decades of this economic consensus, developing countries suffered these “pro-cyclical” policies which accentuated rather than countered the recessionary tendencies, and that worsened and prolonged the crisis.  No wonder many of the countries called it the “lost decades.”

When it was the turn of the developed countries to fall into deep economic crisis, suddenly the Keynesian policies to counter recession became not only the fashion but the rage again.  Economic orthodoxy was turned upside down in the home of the Washington Consensus itself.

The state, so vilified in recent years, became the commander again, and trillions of dollars were spent in bailing out failed banks and companies, as well as in pumping liquidity into the system to avert a collapse, while interest rates went to rock bottom and government spending ballooned.

The Keynesian counter-cyclical medicine worked, and a recovery has taken place in several developed countries, so that GNP growth has turned from negative to positive. 

In many developing countries which have the policy space and the funds, similar Keynesian measures were taken, a combination of fiscal stimulus and easy monetary policy.

The shock therapy seems to have worked in rescuing the financial system as well as in stemming the sharp downward trend in GNP.

But in many countries where government debt is high, the limits of fast government spending and easy money have been reached, and dramatically too.

They are learning the hard way that servicing of government debt and new loans for a growing government deficit requires there sufficient funds either from investors in the market or through the “printing of money” (the government lending to itself), and if there are insufficient funds then a default situation looms.

This is the crisis that Greece is going through.  As a member of the eurozone, and with the government not having the authority to print money or devalue its currency, the country has to depend on investors or creditors to roll over existing debt and to buy provide new loans to fund the current year's budget deficit.

The inability of Greece to obtain the new market loans required meant an imminent default of some 8 billion euros of loans coming due this month.  To avoid default, it sought credit from fellow European governments and the IMF.

The initial package of 40-50 billion euros did not stem the loss of investor confidence, so a new package of 110 billion euros was put together and when this also did not work the European leaders and the IMF have now come up with a mega package of almost 1 trillion euros from which Greece and other European countries can draw from to avoid a financial meltdown.

Still, many economic experts, writing in the Financial Times and elsewhere, have assessed that although the amounts pledged to bail out Greece may meet its credit needs for a few years, the debts of Greece would still be growing and it would again be facing a default situation at the end of two or three years.

The emerging view is that it is better to recognise this, and to arrange upfront for an orderly debt workout in which creditors take a “haircut” (agree to be paid back only part of the debt owed to them), and the country is able to start again on a more sound footing.

Otherwise Greece will have to undergo a period of tremendous austerity.  Its announced policy package of salary and pension cuts, and reduced spending, geared towards reducing the government deficit, is predicted to have the economy in recession for some years. 

The strong street protests and strikes have already begun, even before the policies are implemented, raising the question whether Greece will be able to sustain the required policies.

The new fear is that there will be contagion from Greece to other weak European countries, such as Portugal, Spain and Ireland, and even the United Kingdom is being talked about as a potential crisis country.

The one trillion euro package was quickly put together by European leaders to prevent the potential of contagion from becoming a reality.

The countries are now embarking on austerity policies to avoid becoming the next Greece.   Last week, the Spanish Prime Minister announced sweeping spending cuts of 15 billion euros including a 5% reduction in public servants' pay.

Portugal announced it would cut its government deficit from 9.4% of GNP this year to 4.6% of GNP next year, including through tax hikes and salary cuts.

And the new Treasury chief of the United Kingdom, George Osborne, pledged to accelerate spending cuts to reduce the government deficit from its high 12% of GNP.

From the mantra of fiscal stimulus which was the rage of the last two years, the new concern is to slash government spending and deficits, and prove to the markets that the country is credit worthy.

What this means is that the developed countries can be expected to be in a state of low growth or worse in the next several years, as the Keynesian prop of increased government spending has reached its useful limit and an exit policy is being sought for the fiscal stimulus. 

For developing countries, the implication is that there are limits too to the old model of export-led growth dependent on the rich economies.  Exports may still grow, but at a reduced rate.

They have to look more to themselves to fill in the gap left by reduced export growth, and for the generation of demand to drive future development, either their own domestic market, or their regional markets, and the markets South-South across continents.