Global Trends by Martin Khor

Monday 16 January 2012

Fiscal austerity causing new recession

From fiscal stimulus, developed countries have moved to fiscal austerity which is causing a new global recession, according to a new UN paper.


Austerity measures by governments of many developed countries have been criticized by prominent economists Joseph Stiglitz and Paul Krugman as wrong policies when economies are weak and unemployment high.

The quick half-recovery from the 2008-9 global recession was largely due to fiscal stimulus or expanded government spending in both the developed countries as well as developing countries including China, India and Malaysia.

Fiscal stimulus became the new orthodoxy.  But less than two years later, the old orthodoxy, based on fears of inflation and budget deficits re-emerged.

‘Fiscal austerity’ involving cuts in government spending has quickly replaced fiscal stimulus as the ruling paradigm, especially in Europe.

The year 2012 will see which of the two will become reality -- the policy makers’ expectations of recovery-through-austerity or the Keynesian economists’ prediction of austerity-led recession. 

The UN Conference on Trade and Development (UNCTAD) has recently issued a policy paper with the stark title, “On the Brink: Fiscal Austerity Threatens a Global Recession.”

Its chief author, Heiner Flassbeck, warns that fiscal austerity policies being implemented by countries are driving the global economy towards a recession.

‘The vicious circle induced by fiscal contraction, weak financial institutions and financially fragile households is fuelling a crisis of confidence and holding back investment and job creation in the private and public sectors simultaneously’ said Flassbeck, an UNCTAD Director, and former German deputy finance minister.

‘The countries threatened by recession and deflation should avoid intensified austerity measures because these are unlikely to produce the intended outcomes and could propel the world into a renewed bout of recession, or even into an outright depression.’

The UNCTAD paper warns of a ‘lost decade’ for the world economy that would risk the development gains achieved during the recent years, and ‘throw into question the ability of democratic governments to tackle the most urgent challenges of our age.’

It proposes expansionary fiscal policies in key economies.  Only these can open a path towards lower fiscal deficits and falling public debt ratios.

Key points in the UNCTAD paper include:

• High unemployment is a more pressing problem now than fiscal imbalances.

• Fiscal austerity in the current environment will make matters worse, not better.

• Contractionary contagion will affect all countries and developing economies need to prepare contingency plan.

UNCTAD said that in 2011, most advanced economies either suspended or reversed their expansionary policies.  They hoped to bring about an “expansionary contraction” where fiscal restraint would improve private sector confidence and spending.

These hopes are rapidly waning as new data points to a fully-fledged recession. Most advanced countries implementing austerity policies have experienced, instead, a “contractionary contraction”.

Private sector confidence is reaching new lows, as demand from governments and from public sector employees falls relentlessly.

A review by UNCTAD of scores of cases of countries (including many developing countries coming under the IMF’s structural adjustment programmes) in the past two decades showed that fiscal tightening did not trigger the sought-after economic expansion but rather had the opposite effect.

It called for a co-ordinated expansionary policy alternative including the following elements:

* Countries threatened by recession and deflation should avoid intensified austerity measures.

* Countries should see fiscal policies as tools for growth and development, instead of having a fiscal-phobic approach. Instead of asking whether their fiscal deficit is “too big”, they should consider whether it is being used in the best way to stimulate the economy.

* Fiscal space can be shrunk or expanded according to the mix of policies that governments choose, with a variable impact on employment, tax revenues and economic growth.

Tighter fiscal policies have often led to reduced investment, job losses, reduced fiscal revenues, and stagnant or falling GDP growth.  In contrast, expansionary fiscal policy can boost consumer demand, increase public investment and stimulate private investment and incomes. These can lead to higher tax revenues and a lower fiscal deficit.

Social spending in can also promote recovery by sustaining consumption during a crisis while tax cuts that benefit lower income households can have a stronger impact on aggregate demand because poorer households spend a larger share of their revenues.

* Fiscal space can protect vulnerable economies against external shocks. Countries should seek to enlarge their fiscal space through the use of appropriate tax policies, and by building up a strong fiscal position in times of economic prosperity.