Why is austerity so unpopular in Europe? Because it’s not working.

at 11:30 AM ET, 05/07/2012

Europeans are rebelling against austerity. That’s the read on Sunday’s elections in Greece and France. But why do voters loathe austerity? Perhaps because, as economists have found, efforts to rein in budget deficits can take a wrenching toll on living standards, especially in a recession.


A casualty of austerity. (Francois Mori — Associated Press)
In a recent paper for the International Monetary Fund, Laurence Ball, Daniel Leigh and Prakash Loungani looked at 173 episodes of fiscal austerity over the past 30 years. These were countries that, for one reason or another, cut spending and/or raised taxes to shrink their budget deficits. And the results were typically painful: Austerity, the IMF paper found, “lowers incomes in the short term, with wage-earners taking more of a hit than others; it also raises unemployment, particularly long-term unemployment.”

Specifically, an austerity program that curbs the deficit by 1 percent of GDP reduces real incomes by about 0.6 percent and raises unemployment by almost 0.5 percentage points. What’s more, the IMF found, the losses are twice as big when the central bank can’t or won’t cut interest rates (that’s a good description of what Europe’s central bank is doing right now). Income and employment don’t fully recover even five years after the austerity program is enacted:

This is more or less the situation that Europe’s facing. In 2011, Greece’s austerity package amounted to 11.1 percent of GDP. Spain’s was 3.1 percent. Great Britain’s was 2 percent. Italy’s was 1.8 percent. Those include a mix of spending cuts and tax hikes. If the IMF paper is correct, those measures will pinch sharply for years. And many of these countries were already struggling with soaring unemployment. Little wonder that austerity isn’t popular.

Now, the IMF authors point out that fiscal consolidation is still worth pursuing in certain cases. Some countries really do run up against unmanageable debt levels. Greece, for example, is broke. For years, the government was essentially lying about its finances. At this point, Greece’s main options are to exit the euro zone — with all the chaos that that entails — or to stagger along with a bailout from the E.U. and the IMF. So far, Greece has chosen the bailout. But as a condition of the funds, E.U. and IMF officials demanded big budget cuts and tax hikes. And those measures are having a devastating effect on ordinary Greeks. And so, on Sunday, Greek voters threw out the pro-bailout parties.

But Greece is something of a special case within Europe. Other now-troubled European countries, such as Spain and Ireland, were acting quite responsibly, budget-wise, before the 2007 recession hit. Their deficits then soared because their housing bubbles burst and their economies collapsed. And the rules of the euro zone decreed that these countries needed to respond by curtailing their deficits. But the resulting austerity has been crippling economic growth — and, in the case of countries like Spain, all that belt-tigthening seems to be making the deficit situation worse, not better. Lately, Spanish bond yields have been rising sharply, an indication that investors are leery of Spain’s ability to repay its debts.

So if austerity’s not working, what’s the alternative? In the Financial Times, Gavyn Davies recently argued that Spain needed other remedies besides its “austerity trap.” His proposals included everything from higher inflation to looser monetary policy from Europe’s central bank to significant labor-market reforms. Similarly, Francois Hollande, France’s new president, has argued that euro zone countries needed more economic growth, and not simply more austerity, to get through the crisis.

It’s not clear that Europe’s leaders will move in this direction. Germany is the most powerful country in the euro zone, and many of Germany’s key policymakers are still very much in favor of austerity as the main solution to the euro zone’s woes. But with voters now in revolt, it’s unclear how long Europe will be able to stay the course.

Related: Are there alternatives to austerity in Europe? Here are six.

 
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