[Considerably more feasible than the right wing government’s deficit reduction plan.[

The rightwing Spanish government plans a new 65 billion euro austerity package, while the no less rightwing Greek coalition hopes to reduce public sending by 11.7 billion.  By accident or mis-design both hope to reduce net public sector spending over two years (2012-2013) by five percent of this year’s GDP.  After several years of economic decline, these cuts make no economic sense and are inhumanly callous.  We must, however, grudgingly accept that whether necessary or not, the cuts and taxes will reduce the large fiscal deficits of those countries.
Actually, we should not.  In Greece and Spain the successful (if that is the appropriate word) implementation of spending cuts and tax increases is likely to have no substantial deficit reduction effect.  It might even drive public finances deeper into the red.  To understand why this apparently perverse outcome is the likely one, I must start with the deficit measure used by the mad men and women in the Triad (European Commission, International Monetary Fund and European Central Bank, with the first a semi-surrogate for the government in Berlin). 
The deficit that the Triadic Scrooges so fervently wish to cut is the overall budget balance, total revenue minus total expenditure, as a share of gross domestic product.  I have in other articles in the SEJ demonstrated that this is the wrong technical measure for the objective that the Triadic fiscal hawks seek, foolish as that objective is.  They should use the primary balance, which is the overall balance minus interest payments.

By whatever measure they might use, the Triad operates under the firm conviction that if a government spends less, this will reduce the ratio of the fiscal balance to GDP.  But, will it? 
The level of GDP (national output) is determined in the short run by how much households, businesses, governments and foreigners buy (less what the locals buy from abroad).  This generalization comes from the commonsense inference that if products and services go unsold, they will not continue to be produced.  When a government reduces its expenditures, it simultaneously reduces production, partly its own and partly that of the private sector.  For example, a reduction in spending on health care might consist of firing nurses from the public sector, plus buying fewer medicines from the private.

If cuts and nothing else happened, the deficit measure used by the triad must fall (become less negative).  For example, if public expenditure is 15 euros, public revenue is ten euros, and GDP one hundred euros, the fiscal deficit is five percent of GDP.  If nothing else changes, a cut in spending of five euros eliminates the deficit (the public balance becomes [10 – 10]/95 = zero).  True, national income has fallen by the amount of the spending cut, unemployment rises, but the deficit is gone.  With the deficit gone, the famously capricious financial markets will calm, and the economy will recovery (check with the somewhat beleaguered UK Chancellor George Osborne on the details of this recovery process).

Not so fast.  The reduction in public spending is a fall in household and business income.  As a result of this fall, business and household tax revenue decline.  These declines are well-recognized and documented.  The Organization of Economic Cooperation and Development (OECD) estimates that the average elasticity across the euro countries of changes in corporate tax to changes in GDP is 1.38.  Thus, a one percent rise in GDP increases corporate tax revenue by 1.38 percent, and the same statistic for household income tax is 1.48.  When GDP falls the reverse occurs (see Escolano, page 19, full reference below).  When a government cuts expenditure, by reducing national output it also reduces its revenue.

The story is still not complete.  The fall in household income brought on by the budget cuts occurs because some people lose their jobs (quite a few in Spain and Greece, as matter of fact).  In every euro country, people who lose their jobs receive support payments, with some countries more generous than others.  The OECD estimates that the average across euro countries for the elasticity of all current expenditures (these exclude public investment) to GDP is minus .11.  The negative sign means that a decline in GDP of one percent increases these expenditures by .11 percent.

Our work can only happen with the sustained support of our viewers. Will you join our campaign for independent radical journalism by making a gift today?

The final element in the story is how much national income falls when public expenditure is cut.  I simplistically presumed a one-to-one relationship.  It is never this simple, because the income lost by laid-off public servants will lead to less spending by them in shops.  The shops will reduce orders to wholesalers, wholesalers will cancel orders to factories, etc. etc.  In periods of recession (like now, as you may have noticed) the change in national income to changes in pubic expenditure is substantially greater than one-to-one (see discussion at the Royal Economics Society website, http://www.res.org.uk/view/article4Apr12Correspondence.html).

I can now summarize.  A reduction in government expenditure results in a fall in national income and employment, which decreases tax revenue and increases social support payments:

Public expenditure falls

 

>> national income falls

MINUS tax revenue

 

PLUS social support

Deficit target >>

= [tax – spending]/GDP

up or down?

Using the statistics from the OECD, I first estimated the likely impact of the announced expenditure cuts in Greece and Spain on gross national product (the bottom of the Triadic deficit ratio).  This is shown in Chart 1.  For Greece, the 11.7 billion euro package, when split equally between 2012 and 2013, results in growth declines of 4.4 and 4.6 percent, respectively.  It is probable that these numbers underestimate the declines.  They do not include the almost certain possibility of falling private investment that would aggravate the public sector cuts.  Underestimation is also implied because these declines are considerably less than the seven percent contraction in 2011.  It is unlikely that new cuts added to the old would reduce the rate of national income decline (quite the contrary).

For Spain the declines in GDP are less, minus 3.8 and minus four percent for 2012 and 2013.  The smaller contraction for Spain, despite the same relative cut in public expenditure as in Greece, results the different structures of expenditures and taxes in the two countries.

In 2011, the Greek and Spanish fiscal balances were minus 9.2 and minus 8.5 percent of GDP.  We can predict with total confidence that cutting net spending in both countries by five percentage points of GDP, will not reduce the deficits by that same five percentage points;  that is, to (-9.2 + 5.0) = – 4.2 (Greece), and (-8.5 + 5.0) = -3.5 (Spain).

My calculations, shown in Chart 2, indicate that the deficit reduction for Greece will be trivial, from minus 9.2 in 2011 to minus 8.8 in 2013.  In the case of Spain, the calculated fiscal balance increases, from minus 8.5 in 2011 to minus 8.8 in 2013.  These results have straight-forward explanations.  The downward inflexibility Greek deficit results in great part from the enormous debt service payments of the government, almost seven percent of national income in 2011.  Cuts in these would mean government default.

It is important to note that if the Triadic demand for deficit reduction referred to the appropriate measure, the primary deficit, the Greeks in 2011 would have met the infamous Maastricht Criterion of three percent of GDP (overall deficit of 9.2 minus the debt payments of 6.8, yields a primary deficit of 2.6). In the case of Spain, the cuts make the deficit worse because of the sensitivity of social support payments to falls in output and employment.  The Greek deficit problem would become “manageable” by the simple step of measuring it in a technically competent manner.  The Spain problem would be solved by growth, which would rapidly reverse the vicious circle of cuts-contraction-deficit.

Chart 1: Actual and calculated GDP for Greece and Spain, 2008-2011
(index, 2008 = 100, constant prices)

[Statistics from oecd.org]

Chart 2: Actual and calculated Overall Fiscal Balance as percentage of GDP
for Greece and Spain, 2008-2011

[Statistics from oecd.org[

A final comment on Spain is necessary.  The recent and repeated anxiety that a seven percent borrowing rate represents a threshold or literal deadline above which Spanish debt is non-sustain has no rational basis.  Today, with the public borrowing rate in the 7-7.5 percent range, interest payments of the Spanish government on its debt are barely 2.5 percent of GDP, the same as the German government whose borrowing rate is much lower.  Even more important, in the mid-1990s every important indicator of Spanish debt sustainability was “worse” than now (see Chart 3).  The net debt (public liabilities less liquid assets) was higher than the OECD forecast for the end of 2012.  At eleven percent in the 1990s, the public sector borrowing rate was well above the allegedly unsustainable seven. And, debt service in the mid-1990s was over four percent of GDP, compared to less than three today.

The exit from Spain’s present debt and deficit problems will be achieved in the same way it was during the second half of the 1990s and into the 2000s, by output growth.  The growth must come from public sector action, a fiscal stimulus.

Chart 3: Debt Sustainability in Spain, 1994-2012
(net public debt on left axis in percentage of GDP, interest payments/GDP and borrowing rate on right axis, percentages)

[Note: Net Public Debt is gross minus liquid assets as share of GDP, IntPD/GDP is interest on the public debt as share of GDP.  Values for 2012 are projections by OECD, except for the interest rate which is the public bond rate at end of July 2012.]

Albert Einstein famously remarked that doing the same thing repeatedly and expecting a different outcome is a sign of madness.  In the case of the Triad, Einstein’s comment must be considered a hypothesis to take seriously.  I think it is a more credible hypothesis to explain the euro crisis than a frequently offered alternative, “kicking the can down the road” hypothesis.  This explains the on-going crisis as a muddle resulting from lack of resolution and foresight by EU politicians.

A third hypothesis carries considerably more weight with me than transitory madness or dented cans, namely, the national self interest hypothesis.  The common currency arrangement has proved a tremendous advantage for large German capital, as I have argued in other articles.  To put it simply, strict inflation control, largely through real wage restraint, provided German industry with a tremendous competitive advantage over euro countries not pursing the same mercantilist trade strategy.  The financial power generated by aggressive export-led growth has served the interests of those in Germany seeking economic pre-dominance in Europe.  In my view the German government’s strategy is, stretch out this crisis as long as possible.  The weak will leave and those that remain will themselves be too weak to challenge to German self-interest as it is perceived by the present government in Berlin.  One might say that the re-unification of Germany has run its course.

Escolano, Julio (2010) A Practical Guide to Public Debt Dynamics, Fiscal Sustainability, and Cyclical Adjustment of Budgetary Aggregates, Technical Notes and Manuals, Fiscal Affairs Department (Washington: IMF)

John Weeks

John Weeks is Professor Emeritus and Senior Researcher at the Centre for Development Policy and Research, and Research on Money and Finance Group at the School of Oriental & African Studies at the University of London.