The Swedish lessons for Europe

Fiscal austerity is the current buzzword in macroeconomic policymaking. Across Europe, despite very strong domestic political opposition, governments have embraced wildly ambitious fiscal adjustment targets in an attempt to rein in soaring public debts, restore market confidence, and thereby engineer economic recovery. 

However, evidence from nearly three years of such experimentation across Britain and the Eurozone economies has been dismal. Bond markets have remained unimpressed and sovereign bond yields continue to rise. Not only have the expected recovery not materialized, but these economies have slipped further down the abyss. And this has been the fate of economies within and outside the Eurozone. The latest casualty is Britain, which has officially slipped into a double-dip recession, its second recession in three years. It joins Belgium, the Czech Republic, Greece, Italy, the Netherlands and Spain who are already in recession.

As with Greece, Ireland, and Portugal earlier, Spain too is now experiencing the wages of the same austerity medicine. Amidst a contracting economy, its sovereign debt rating has been downgraded and cost of borrowing has been rising. One-in-four Spaniards are unemployed and half all Spanish youth are out of work, both the highest among advanced economies. Even with all the belt-tightening, Spain is expected to easily miss its target of lowering budget deficit from 8.5% of GDP to 5.3% in 2012 and do no better than 6.2% .   

As could have been anticipated, the blind embrace of austerity has had the effect of accepting the worst of all worlds. As economic growth has contracted, public debt-to-GDP ratios have gone up even higher and tax revenues have dipped sharply. In the absence of either the private sector or external sector stepping in top stanch the space vacated by public expenditures, it was natural that the economy would contract.

All this has raised unemployment rates and inflicted untold suffering on citizens across Europe. Economic hardship have triggered off pent-up social tensions. Political rebellions and protests have become commonplace in these countries. Many governments have lost power in the face of street protests and failures to push through the tough fiscal adjustment measures required to secure external funds. At last count governments in Greece, Ireland, Italy, Portugal, Spain, Netherlands, and now Romania have lost power due to the pains caused by spending cuts.     

In this context, it has become important that these economies abandon their dogmatic ideological embrace of austerity and fall back on policies that can get their economies growing. Robert Samuelson has a nice article which highlights the less-discussed economic turnaround of Sweden since its banking crisis induced economic recession in early nineties. In recent years, Sweden has emerged, along with Germany, as among the best performing developed economies.

Instead of being wedded to ideology-driven policies, Sweden embraced prudent policies that combined both the conservative and liberal social and economic agendas. For a start, it did not bail out its banks but forced them to take massive losses and virtually nationalized its banking sector. The real estate bubble that was inflated by the financial deregulation of the 1980s deflated in 1991-92. As pressure mounted on the krona, overnight interest rates spiked to 500%, and the Swedish economy contracted steeply and unemployment quadrupled in three years to 12%. After a series of bank failures, the government moved in swiftly with a series of measures,

In September 1992... the government announced that the Swedish state would guarantee all bank deposits and creditors of the nation’s 114 banks. Sweden formed a new agency to supervise institutions that needed recapitalization, and another that sold off the assets, mainly real estate, that the banks held as collateral. Sweden told its banks to write down their losses promptly before coming to the state for recapitalization. Facing its own problem later in the decade, Japan made the mistake of dragging this process out, delaying a solution for years...

By the end of the crisis, the Swedish government had seized a vast portion of the banking sector, and the agency had mostly fulfilled its hard-nosed mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again.

This was followed with several far-reaching structural reforms that turned the largely statist economy into one of the world's most dynamic economies, without compromising on its social-democratic principles. The reforms drew from both the conservative and liberal playbooks,  

Sweden’s income tax base was broadened and tax rates were sharply reduced (marginal tax rates fell from 46% in 1996 to 33% in 2010). Spending was cut on old-age pensions, child allowances, unemployment benefits and housing subsidies. Union power over wages was reduced. Many markets (banking, air travel, telecommunications, electricity production) were deregulated. Low inflation and balanced budgets became broadly embraced popular goals...

Although Sweden trimmed social benefits, it hardly abandoned the welfare state. Overall government spending is still about 50 percent of the GDP, much higher than in the United States... To reduce income tax rates, the government raised other taxes. Gasoline and cigarette taxes were increased; so were taxes on dividends and capital gains, hitting the rich. Altogether, deficit reduction totaled a huge 12 percent of GDP from 1991 to 1998. Slightly more than a third of that came from higher taxes...

The aims were clear: to reward work by cutting income tax rates; to push people back into the labor market by reducing some government benefits; and to promote productivity by increasing competition. Productivity and “real” (after-inflation) wage gains improved markedly. Still, Sweden has less economic inequality than most advanced countries.

Sweden also benefited from favorable external economic conditions. Its recession coincided with a sustained period of economic strength across much of the world. Sweden could therefore export its way out of recession. A 25% devaluation of the krona boosted exports. Unfortunately, none of the peripheral European economices today can afford this luxury. None of the Eurozone economies have the freedom to undertake this policy route. See also this excellent presentation by Swedish Finance Minister Anders Borg.

The choices facing Eurozone governments are stark. Currently the austerity policies are merely pushing their economies down the hill, with no hope of finding an anchor that can drive economic recovery in the foreseeable future. It is necessary for all the Eurozone economies to start regaining their economic competitiveness for any sustained recovery to take hold. This can happen only with either a Eurozone exit and/or fiscal transfers from the Eurozone's center. There has to be some period of fiscal accommodation in the periphery and consumption increase in the center.

This is an opportunity to push through the tough labour market liberalization and industry dergulation policies that have for long contributed to sclerosis in Europe. More than that it is an opportunity for the Europen monetary union to become a loose political union, a necessary requirement for the continent to stave off similar situations in future, leave alone escape the current mess.   

Hysteresis effects of recessions

What are the long-term consequences of prolonged periods of high unemployment and slower economic growth? As economic growth returns back to normal levels, does the labour market recover to its pre-crisis normal? Does capital investment by businesses and investments in research and development regain its pre-crisis trends? In simple terms, how much time does it take for the actual output to close the gap with the potential output? Or is there a danger that a permanent output gap will get crystallized?

In a recent paper, Brad DeLong and Lawrence Summers highlighted the important role of hysteresis effects. They claim that a long enough recession can erode the capability of both human and physical capital, and recovery cannot be taken for granted. There is enough evidence that long-term unemployment has scarring effects on those affected. I have blogged earlier about the harmful effects of long-term unemployment.

Greg Ip has written in Free Exchange about the possibility that America's potential output itself may have come down during the Great Recession. He points to the reduction in labour force participation rate, which appears to have stabilized at a lower level, and the lower (than trend rate) productivity rate in recent years. He argues that the actual output has been depressed for so long that hysteresis has set in and dragged the potential output down with it.

Mark Thoma has a striking illustration of the long-term consequences of deep recessions by pointing to the example of East Asian economies after their recessions following the 1997 currency devaluation crisis. All the major East Asian economies - South Korea, Malaysia, Indonesia, Hong Kong and Thailand - continue to remain considerably behind their long-term trend growth rates, even a decade after that crisis.











Much the same fate has befallen Japan since its early nineties asset prices crash. The economy fell-off the trend line for a prolonged period. Though there were signs of a recovery in the second half of last decade, the sub-prime crisis appears to have snuffed that out.


If hysteresis does indeed drag and keep down growth, then that alone would be a strong enough reason for governments to indulge in aggressive monetary and fiscal accommodation to boost aggregate demand and ensure that all idling resources are optimally employed.

The Great Recession, Stimulus Bill, and the US economy

Brad Plumer points to these two excellent graphics (from the Economic Report of the US President) that maps the impact of fourteen cases of banking/financial crises induced economic recessions from across the world.

1. The average increase in unemployment rate from the peak of the business cycle is 7.7 percentage points for the 14 cases, whereas in the Great Recession during 2007-09, the US economy suffered a 5.1 percentage points rise unemployment rate.



2. The average cumulative decline in real GDP from the business cycle peak for the 14 cases has been 10.2 percentage points and the average duration of recessions has been 6.6 quarters, measured as the number of quarters between the peak and trough of real output. In the Great Recession, the US economy suffered a 5.1 percentage points cumulative drop in real output and it has taken 6 quarters to regain the lost output.



There have been many studies which have examined the impact of the American Recovery and Reinvestment Act 2009 in shortening the recession and keeping unemployment rates from getting higher. This summary of nine economic studies on the stimulus bill reveals that six found a significant positive effect on growth and unemployment, while three found either a small or hard-to-predict effect. The US President's Council of Economic Advisers' most recent assessment of the ARRA found that, as of mid-2011, there would’ve been between 2.2 million and 4.2 million fewer Americans employed if the bill had never passed.

The graphics below, from the CEA report, highlight the impact of ARRA on the post-ARRA GDP and employment creation.




But the recession has surely taken a toll on the US economy. The graphic below shows that the Bush era tax cuts and lost revenues from the economic downturn are the major contributors to America's massive fiscal deficit.

Expansionary Austerity - a Guide to Killing Zombie Economists

Pondering the puzzle of far too many zombie economists, many of European, English, and American fresh-water origin, I started researching how to REALLY kill a zombie.

The recent tragic British recessionary news motivates this research. Britain receded into a recession in the fourth quarter, making the current depression the longest even considering the prior depression. This NIESR chart is from Jonathan Portes, Director, National Institute of Economic and Social Research, previously, Chief Economist at the UK Cabinet Office. Notice that, in Britain, this depression is also almost as deep as the prior one.


Menzie Chinn, of the University of Wisconsin, Madison, also weighs in with his view which highlights the drastic difference that zombie-supporting political ideologues make in the affairs of nations. Here is his chart:

And Chris Dillow, via Mark Thoma, both have the same question I do (minus the zombie part).

So, I feel I am on solid ground in my quest. The best reference so far for killing zombies (not refereed a.f.a.i.k.), seems to be the Zombie Wiki.

The essential step, though there are many, is destroying the brain of the zombie. That sounds about right to me, though I would hope these charts and the recent IMF studies would destroy the offending brain cells. I think it's way past time that expansionary austerity die its deserved death. Waiting for dark, got my high power flash and brain destroying implements. Off to hunt Zombies.

Can anyone identify the economist in the opening picture?

Update: Here is a link to the IMF Working Paper; the conclusion is at page 30, but take a minute to browse their graphs. Austerity is contractionary.

Country out of recession, people still in recession?

The NYT has this (see article here) excellent graphic that captures the incongruity of any formal declaration of the end of recession in the US. Adjusted for inflation, median household incomes have continued to fall unabated despite the formal end of recession.



Then there is the biggest problem facing the US economy, an unprecedented jobs crisis. Unemployment rate appears to have hit at plateau at around 9%. As the graphic below shows, rate of non-farm job creation has declined precipitously in comparison to the nineties.



Ironically, even as households are bearing the brunt of the recession and the jobs crisis shows no signs of an end anytime soon, the rest of the economy appears to have made smart recoveries. The profits of non-financial corporations has recovered to pre-crisis levels and non-financial businesses are sitting on cash surpluses worth more than $2 trillion.



And Wall Street, especially the bigger institutions, appear to have regained much of lost ground - financial sector profits and executive compensation are back to business as usual.

Austerity before recovery in G-7 economies

All talk of austerity and fiscal consolidation masks the alarming fact that three-and-half years since the recession struck, the economic output of all G-7 economies, except Canada, remains below the pre-recession peak. In other words, but for Canada, none of the others, including Germany, have regained their GDP lost during the recession.



The graphic below captures the quarterly real GDP trajectories, including the latest of Q2 2011, of all the seven economies since the pre-recession peak.

"Great Contraction", not "Great Recession"?

Carmen Reinhart and Ken Rogoff, the foremost historians of financial market crises, have consistently cautioned against any misplaced optimism for a quick recovery from the depths of the sub-prime crisis. They have pointed to historical evidence to argue that it takes typically more than four years for an economy hit by a deep financial crisis to just recover to the same pre-crisis per capita income level. The evidence so far, for most macroeconomic indicators, has pretty much squared up with their findings.







Though they have opposed contractionary policies to reduce public debts in the US, they have also questioned the effectiveness of large fiscal stimulus. They reject the arguments of those advocating expansionary policies who blame the current state of the US economy to inadequate fiscal stimulus spending. They argue that this policy approach can be useful in combating a "recession", but not a debt-driven "contraction". In such financial meltdown induced contractions, the major problem is debt-laden consumers and businesses.



As to possible prescriptions, Kenneth Rogoff advocates policies that "catalyze debt workouts and reductions" and "moderate inflation". He writes,

"Governments could facilitate the write-down of mortgages in exchange for a share of any future home-price appreciation. An analogous approach can be done for countries. For example, rich countries’ voters in Europe could perhaps be persuaded to engage in a much larger bailout for Greece (one that is actually big enough to work), in exchange for higher payments in ten to fifteen years if Greek growth outperforms....



The only practical way to shorten the coming period of painful deleveraging and slow growth would be a sustained burst of moderate inflation, say, 4-6% for several years... inflation is an unfair and arbitrary transfer of income from savers to debtors. But... such a transfer is the most direct approach to faster recovery. Eventually, it will take place one way or another, anyway..."

This line of analysis, with its focus on reducing the debt exposure, is similar to the "balance sheet recession" analysis of Richard Koo. He argues that the sub-prime meltdown had left the balance sheets of households and financial institutions in tatters. The financial market bailout program, TARP, and the extraordinary quantitative easing measures have effectively backstopped the losses of financial institutions.



However, there have been nothing similar to bailout households, especially those facing foreclosures and negative equity with their housing mortgages. The result is that consumers, whose consumption forms 70% of the US GDP, remains subdued, even deepressed. The knock-on effect on business investments and the labour market is there to see. As Ken Rogoff suggests, some form of partial and conditional write-downs of certain mortgages, and tax cuts that could be used to pay-off debts, would be the most appropriate fiscal expansion measures for such times.



Update 1 (5/8/2011)



Larry Summers makes the point that tax receipts over the next decade would be about $1 trillion lower — and debt that much larger — if economic growth were shaved by half a percentage point a year. This is about the same amount that the debt deal bill passed by the US Congress claims it will save.



Update 2 (15/8/2011)



The biggest restraint on consumer spending in the US has been the debt hangover. Since August 2008, when household debt peaked at $12.41 trillion, it has declined by about $1.2 trillion, according to an analysis by Moody’s Analytics of data from the Federal Reserve and Equifax, the credit agency. A large portion of that, though, was simply written off by lenders as borrowers defaulted on loans. However, the proportion of after-tax income that households spend to remain current on loan payments has fallen, from close to 14 percent in early 2007 to 11.5 percent now.







Still, household debt as a percentage of GDP remains high, far higher than its pre-nineties rate. It is reasonable to argue that the economy cannot achieve true health until debt levels decline, even with the ultra-low rates and the commitment to keep them low till atleast mid-2013.

The call for austerity - cure worsens the disease?

Carmen Reinhart and Ken Rogoff, the foremost historians of macroeconomic crises, have an excellent article in Bloomberg, where they express concern at the high debt overhang among developed economies.



Their magisterial examination of the history of financial crises and the relationship between growth and public liabilities found that when the debt-to-GDP ratio exceeds 90% in case of developed economies, it starts having adverse impact on long-term growth and macroeconomic stability. And this level has either been already breached or is fast approaching in most developed economies.



They cast doubt on the arguement of advocates of fiscal expansion, who claim that the ultra-low interest rates justify another round of stimulus despite the high public debt ratios. They argue that market interest rates can change dramatically in a few months with disastrous cascading consequences, whereas debt reduction takes years. Further, as the Japan example shows, high debt overhang, even without high interest rates, can hinder growth.



Though this analysis cannot be faulted, the implied solution - reining in debt with austerity and tax increases - is fraught with even bigger dangers. As I blogged earlier this week, expansionary fiscal consolidation holds limited promise. It contracts private domestic demand and the GDP. This should not come as a surprise since private consumption and business investment, which form the predominant source of growth in the absence of government spending, remains abysmally weak and shows no signs of revival. The only other remaining source of growth, external trade, too holds little promise and in any case cannot provide the thrust for recovering from such a bad crisis in case of large economies. See this and this.



Without private sector consumption and investment recovering, any contraction in government spending will only push the economy further down the recessionary path. The knock-on effect on the revenues side of the fiscal balance will be disastrous.







As has been well documented with the impact of the Great Recession on the US government deficit, the biggest concern during a recession is the reduction in government revenues and the resultant widening of fiscal deficits and debt-to-GDP ratios. In other words, the prescription turns out worsening the disease!



Paul Krugman has this concise response to the two most frequent arguments that deficits will drive up interest rates - government borrowing crowding out private borrowers and driving up rates, and fears of government's solvency frightening off investors and increasing the cost of borrowing.



Update 1 (17/7/2011)



The two big concerns for conservatives who advocate fiscal contraction are fears of high borrowing costs (bond-vigilantes) and high-inflation. These two concerns go against all standard macroeconomic models of economies stuck in slowdowns with interest rates at the zero-bound. Moreoever, they have been proved as wildly misplaced both from experience till date and from all available long-term forecasts.



In fact, quite to the contrary, all evidence points to a period of persistent low interest rates and low inflation (so much so that some economists, including the IMF, have called for raising the inflation target). This points to deflation, accompanied by Japan-style deep recession, as the greater danger now.



As to why the fiscal contraction story continues to grip the imagination of opinion makers, Paul Krugman points to Robert Kutter. They argue that this line of reasoning supports the interests of creditors, with significant exposure in bonds, loans, and cash. Mike Konczal calls it as "wealth and income defense". These rentiers have an interest in keeping inflation down and they positively benefit from a deflationary environment. Unfortunately, these run exactly opposite to the interests of workers and others.



Update 2 (3/9/2011)



Excellent op-ed in the Times which points out how Argentina, faced with similar high unemployment rate and a sovereign default, rebounded not with austerity but with massive fiscal expansion. For a start, the government intervened to keep the value of its currency low. It then increased taxes to finance a New Deal-like public works binge, increasing government spending to 25% GDP from 14% in 2003. It also strengthened its social safety net - the Universal Child Allowance, started in 2009 with support from both the ruling party and the opposition, gives 1.9 million low-income families a monthly stipend of about $42 per child, which helps increase consumption.



The Washington Post writes that a downturn in Europe deepened by choking off government revenues and increasing the demand for public services, could put struggling countries such as Spain and Italy at risk of missing the very deficit-reduction targets that budget cuts and other austerity measures were meant to achieve.

The "wageless and jobless recovery" in the US?

The labor market problems facing the US economy shows no signs of easing even as an ideological battle over the policy alternatives is on. By every imaginable yardstick, the labor market is at its weakest in decades and for all talk of recovery, unemployment rate remains stuck near its recession-time peak.



All labour market figures make very depressing reading. Almost 14 million people, or 9.1% of the labor force, were unemployed in May, with 45% of those unemployed for 27 weeks or more. Another 8.5 million part-time workers wanted but could not find full-time jobs; an additional 2.2 million dropped out of the labor force because they could not find work. The percentage of the population working has fallen to 58% from 63% over the past five years, reducing the number of Americans with jobs by 10 million.

Laura Tyson writes about the other costs of long term unemployment,

"The economic and human costs associated with the jobs crisis are staggering. An extended period of unemployment means lower earnings: workers who return after long-term unemployment earn 20 percent less over the next 15 to 20 years than a worker who was continuously employed. The longer workers are unemployed the more likely they are to lose their skills and drop out of the labor force. And the longer workers are unemployed, the more likely they are to lose their homes, their health and their marriages – and the more likely their children will grow up in poverty - with adverse implications for their health, education, and future incomes."

Now economists from Northwestern University have found that the woes are not confined to persistent unemployment but also includes wage changes. They "found that the current economic recovery in the United States has been unusually skewed in favor of corporate profits and against increased wages for workers". They show that since the recovery began in June 2009 following a deep 18-month recession, "corporate profits captured 88 percent of the growth in real national income while aggregate wages and salaries accounted for only slightly more than 1 percent" of that growth.

They also found that between the second quarter of 2009 and the fourth quarter of 2010, national income rose by $528 billion, with $464 billion of that growth going to pretax corporate profits, while just $7 billion went to aggregate wages and salaries, after accounting for inflation. In other words, the share of income growth going to employee compensation was far lower than in the four other economic recoveries that have occurred over the last three decades.



In fact, each of the indices of corporate profits showed strong growth over the past seven quarters - the index for the Dow Jones industrial average was nearly 46% higher at the end of the 2011 I quarter, and the S&P 500 index was 44% higher in that same quarter. In contrast, the three indices of hourly and weekly real wages of US workers showed little to no positive growth between the second quarter of 2009 and the first quarter of 2011. While each of the three corporate profit and stock value indices were far above their values in the base period, each of our three hourly and weekly wage indices were basically flat.

The BLS data reveals that average real hourly earnings for all employees actually declined by 1.1 percent from June 2009 to May 2011 and real wages and salaries declined by $27 bn over the seven quarters, the first ever such decline in any post-War II recovery. Further, worker productivity has grown just under 6 percent since the recovery began, helping to keep employment down while lifting corporate profits.

There is nothing surprising about this trend. In financial market meltdown induced balance sheet recession, consumers postpone spending and businesses defer investments to pay off their massive accumulated debts. When the magnitude of balance sheet damage is considerable, the recovery takes time, especially without substantial direct support from government. A downward spiral becomes inevitable - since consumer spending goes down, businesses start lay-offs and postpone investments; high unemployment and the excuse of recession also gives them the perfect excuse to squeeze more out of each employee without paying more. Corporate profits rise even as wages stagnate. And dismal economic expectations add to the woes by discouraging businesses from investing. The recovery path becomes a steep and arduous climb up.

Update 1 (4/7/2011)

The debate in the US about the economic policy options is between Conservatives who call for austerity measures to rein in the burgeoning public debt and Liberals who advocate more fiscal austerity to provide the stimulus that can lift the economy from its deep aggregatee demand slump.

Mr John Taylor traces the economy’s ailments to the abandonment of predictable, rules-based fiscal and monetary policies. The bail-outs and stimulus of George Bush junior and Mr Obama, and the Fed’s emergency lending and QE, he argues, sowed paralysing uncertainty. He believes that deep spending cuts would reverse this effect and thus generate private spending and growth.

In contrast, Christina Romer argues that near-term fiscal stimulus, by boosting employment and income, lessens the pressure on households to pay down debt whereas premature austerity could worsen the cycle of weaker growth and deleveraging.

Household debt in US remains well above its normal levels despite all the deleveraging of the past three years. As Carmen and Vince Reinhart have shown, countries that experienced macroeconomic and banking crises could repair their debt overhang only after a prolonged period of deleveraging. While Conservatives say that fiscal stimulus will only substitute private debt for government debt, Liberals argue that such stimulus spending expedites the process of balance sheet repairs.



Since recession ended in June 2009, GDP growth has averaged 2.8%, roughly its long-term trend. After so deep a slump, the pace is usually much faster. The gap between actual and potential GDP has been stuck at around 5% since late 2009.



For the record, the Obama administration has so far injected about $1.2 trillion in fiscal stimulus, the Fed has cut interest rates to nearly zero and then, in two rounds of QE, bought $2.3 trillion of government and mortgage-backed bonds.

Update 1 (19/7/2011)

David Leonhardt has a nice article on the huge consumer spending slump that the US is facing. He writes that,

"The auto industry is on pace to sell 28 percent fewer new vehicles this year than it did 10 years ago — and 10 years ago was 2001, when the country was in recession. Sales of ovens and stoves are on pace to be at their lowest level since 1992. Home sales over the past year have fallen back to their lowest point since the crisis began...

The Federal Reserve Bank of New York recently published a jarring report on what it calls discretionary service spending, a category that excludes housing, food and health care and includes restaurant meals, entertainment, education and even insurance. Going back decades, such spending had never fallen more than 3 percent per capita in a recession. In this slump, it is down almost 7 percent, and still has not really begun to recover...

If you’re looking for one overarching explanation for the still-terrible job market, it is this great consumer bust. Business executives are only rational to hold back on hiring if they do not know when their customers will fully return. Consumers, for their part, are coping with a sharp loss of wealth and an uncertain future (and many have discovered that they don’t need to buy a new car or stove every few years)."

He feels that the US economy is moving away from the debt-financed consumption dominated model that underpinned its growth since the eighties. See the graphic here.

Automatic fiscal stabilizers and counter-cyclical fiscal policy

I have blogged extensively about the utility of fiscal policy in combating aggregate demand slumps, especially when the economy is facing the zero-bound in nominal interest rates.

However, unlike the more rules-based monetary policy, fiscal policy is subjective and deeply political. The classic fiscal policy alternatives like direct government spending on infrastructure face the problem of implementation lags. In contrast, automatic stabilizers kick-in immediately, being targeted on those most likely to spend any money provided to them. It no surprise that automatic stabilizers - unemployment insurance, food stamps etc - have among the highest fiscal multipliers.

The WSJ points to the apparent success of Sweden in managing its recovery from the Great Recession and attributes it to successful expansionary policies by both the government and the Riksbank. The Swedish economy grew 5.5% in 2010 and unemployment rate has fallen from its peak of 9% to 7%. Instead of high-profile direct spending and tax cuts, the Swedish government responded swiftly with automatic stabilizers to provide income, health care and other services to people who are unemployed. The Riksbank, initially lowered rates aggressively to zero, even taking it to minus 0.25% (savers had to pay 0.25% for the privilege of keeping deposits). Its quantitative easing program was more expansionary than even the Fed - the Riksbank's balance sheet was more than 25% of GDP in the summer of 2009, compared to 15% for the Fed.

Further, unlike many other developed economies, Sweden entered the recession in excellent fiscal health - its budget had a 3.6% of GDP surplus in 2007, to 3% deficit in the US. This gave the government enough cushion to indulge in extended fiscal expansion when recession struck. This was a result of a strong commitment, borne out of the bitter experience of its banking and economic crisis in early 1990s, to maintain a counter-cyclical fiscal policy.

Clice Crook points to the example of the US, where though the Obama administration came up with a large fiscal stimulus in 2009, mostly with tax cuts and direct spending, its impact was offset by the severe fiscal tightening by the local governments. He also writes about the relative lack of influence of fiscal stabilizers in the US,

"Two factors weaken automatic stabilizers in the US. First, the government is small, so economic fluctuations, other things being equal, move fiscal quantities less. Second, states are subject to balanced-budget rules. Much of the US government has to follow a pro-cyclical fiscal policy – cutting spending and raising taxes – during a recession."

The acrimonious debates surrounding fiscal expansion in the US underlines the need for a much greater role for automatic fiscal stabilizers. However, it is also important that these automatic stabilizers have automatic sunset clauses that ensure exit from fiscal expansion when the economy recovers. Mark Thoma makes an excellent case for greater use of automatic fiscal stabilizers during recessions.

In this context, Jeffrey Frankel, Carlos A. Vegh, and Guillermo Vuletin (pdf here) examined long-term fiscal policy in 94 countries (73 developing and 21 developed countries) over the 1960-2009 period and found that "the cyclicality of a country’s fiscal policy – a sign of its riskiness – is inversely correlated with the quality of the country’s institutions".

They examined the correlation between government spending and GDP for these countries over two periods, 1960-1999 and 1999-2009, and found a significant increase in countries with negative correlation (or counter-cyclical spending) over the two periods. In fact, among developing countries, those following counter-cyclical policies increased four-fold to 35% over the two periods. The graphic below indicates the correlation between spending and GDP for these countries in the 2000-09 period, with yellow and black bars representing developing and developed countries respectively.



The increase in counter-cyclicality in the conduct of fiscal policy by developing countries is evidence of greater maturity by policy makers and policy institutionalization in these countries. This maturity is corroborated by other indicators like reduced debt-to-GDP ratios in many developing countries. The authors "find that the cyclicality of a country’s fiscal policy is inversely correlated with the country’s institutional quality which includes measures of law and order, bureaucracy quality, corruption, and other risks to investment". They highlight the success of Chile with counter-cyclical fiscal policy and attributes it to institutional strengthening reforms since 1980s.

Global unemployment challenge

The biggest immediate problem facing the developed economies is arguably the persistence of high unemployment rates. As the graphic below reveals, among the major economies, apart from Germany, unemployment rate remains well above the level before the onset of the Great Recession in September 2008.



Its innovative short-work scheme that encouraged companies to keep workers on reduced hours rather than let them go and the strength of its exports sector played a major role in limiting the impact of the Great Recession on the German labor market. Labour market reforms initiated in the last decade too helped Germany retain its competitiveness during the Great Recession.

In the circumstances, contractionary fiscal and monetary policies, driven by fears of burgeoning deficits and inflationary pressures, are only likely to further shrink these economies. This danger is all the more so since aggregate demand is very weak and the private sector is in no position to lead the recovery.

Anemic economy will only exacerbate the debt crisis and increase the debt-to-GDP ratios. As to inflation, given the considerable idling resources in all these economies, it looks like a phantom menace. The immediate challenge should be to get these economies back on some stable recovery path, so that jobs are restored and created, by continuing the expansionary policies for some more time. Or else, we could be staring at a lost decade for developed economies.

Counterfactuals and economic analysis

As the debates on monetary and fiscal policy options during the sub-prime crisis and Great Recession have shown, macroeconomic theories can rarely explain with certainty whether one set of policies are superior to another or are certain to succeed in a given circumstance.

For every example of success with a certain set of policies, opponents are quick to show failures with them. They also point to apparent successes with an alternative set of policies. And in any case, no two situations are the same. Such debates usually end in a stalemate over the relative merits of two opposing theoretical and ideological positions. Further, in such ideological battles, even blatantly untenable views have remarkable persistence. Ideologies are not easily buried.

Since successes or failures with a specific set of policies are rarely cut-and-dry, post-mortems of economic policies too are never non-controversial. For example, despite overwhelming evidence about how TARP and ARRA prevented a complete financial meltdown, created employment and off-set deeper output contraction, sceptics refute the evidence.

Supporters who claim success with a set of policies would face opposition from those arguing that an alternative approach would have yielded better results. Even more, they would argue that conditions would have been better off without those policies - Wall Street would have recovered faster and stronger if there were no bailouts.

Supporters will counter by saying that the recovery would have been more swifter and stronger if their prescriptions were applied in full. For example, economists like Paul Krugman have long argued in favor of much stronger fiscal stimulus measures to mitigate the hardships of the Great Recession. Counter-factuals can only be debated about, never satisfactorily, leave alone conclusively, proven.

The NYT reports of the latest example with such from Europe.

Another missed opportunity for Europe? Over the last year, the European Union and the International Monetary fund have pledged 640 billion euros ($890 billion) to bail out distressed economies on the Continent’s periphery. Yet the interest rates on benchmark bonds in Greece, Ireland and Portugal remain at or near their record highs.

Critics of the bailout will surely see the persistent high interest rates as arising from an inability to convince the confidence fairies and a failure of the policy itself. Supporters would argue that there would have been sovereign defaults from Greece and Ireland in the absence of such bailout backstops.

In simple terms, economic policy are equally handicapped in explaining their policies both ex-ante and ex-post.

Update 1 (28/9/2011)

Paul Krugman has this excellent description of the counterfactual debate on stimulus spending in the US.

The trans-Atlantic debate on igniting economic recovery

When history of the Great Recession will be written, among the primary issues for discussion will be the relative impacts of recovery policies followed across countries.

On the one hand, countries like England, Estonia and Ireland have responded with savage fiscal austerity by cutting wages, spending, and even raising taxes. Across the Atlantic, the US has responded with multiple fiscal stimuluses and continuing monetary accommodation. The major European economies like Germany and France too reacted with stimulus measures, albeit much less muted. Which of these two opposing fiscal policy stances succeeded?

There are two undoubted distinguishing features of the Great Recession. One, aggregate demand has slumped as evidenced by persistently weak consumer spending and the rise in unemployment rate. Second, the balance sheets of households and businesses have been battered by the bursting of the asset bubbles.

Both require different policy prescriptions. An aggregate demand slump would require fiscal policy interventions that would provide money to those people who are likely to spend them. Direct spending measures (like infrastructure works and transfers to local governments) and social safety cushions (like unemployment insurance and food stamps) are ideal for boosting aggregate demand.

Repairing battered balance sheets require policies that help pay off debts or lower its burden or atleast reschedule them. Monetary accommodation for an extended period will lower the debt service burden. Additional credit lines will help mitigate the inevitable liquidity contraction after a financial market meltdown. Since large numbers of people are left with negative housing equity, policies that restructure mortgage debts will help repair household balance sheets. Stimulus spending by way of tax cuts will leave people and businesses with more money which can be used to repay debts.

However, balance sheets cannot be repaired in a hurry. In fact, it will take long for households and firms to shake off the massive debts accummulated. It can only be hoped that some or all of the aforementioned policies work towards helping regain much of the lost ground in asset values. In other words, policies aimed at repairing balance sheets will involve both direct efforts to reduce debt burden and indirectly buy time so that recovery will itself contribute to rebuilding balance sheets.

Both features weigh heavily on the US, British, and Irish economies - aggregate demand is weak and balance sheets of both households and financial institutions are bruised. In addition, government debts too have crossed sustainable levels. But the situation is different with much of continental Europe. They did not experience the same sort of property market bubbles like in the US or Ireland. Accordingly, household balance sheets are less a problem. Their problems lie in financial institutions with massive exposure to their own peripheral economies (the PIIGS).

In case of the PIIGS, all the three - governments, businesses and financial institutions - face deep struggles. All of them borrowed and splurged heavily during the boom and are now facing pay-back time. There is limited fiscal space available for any meaningful stimulus spending. The fiscal austerity, under implementation in some form of the other in all of them, is taking its toll on citizens.

Whatever the specific details of the policies being followed, an immediate return to robust economic growth is critical to the fortunes of all these economies. Strong growth is necessary to not only reduce the high unemployment rates, but more importantly to ensure that the share of public debts do not explode and trigger sovereign defaults.

In the circusmtances, fiscal austerity will leave the entire recovery burden on the private sector. It will have to generate enough growth to not only kick-start growth, but also cover for the loss in GDP due to fiscal contraction. And it will have to achieve this in conditions marked by persistent financial market uncertainty (with resultant high cost of capital), bruised (business and banking) balance sheets, and citizens who will face the brunt of the government's spending cuts. The odds of succeeding against these very formidable obstacles are minimal.

The initial indications from the British experience with fiscal austerity has been disastrous. After four consecutive quarters of modest growth, the economy experienced a contraction in the last quarter of 2010, declining 0.5%. This comes in the back of an extraordinary $128 bn four-year program of spending cuts and tax increases, including an across-the-board reduction of 20% in the budgets of most government departments. Ireland's two year fiscal austerity appears to be leading the country firmly down the sovereign default path. If that is any indicator, England faces a very long and painful struggle ahead.

However, there is one area where the debate about policy responses appears to have been settled. In the aftermath of the sub-prime meltdown, the US Fed and Government responded with great speed and pumped in massive amounts of liquidity to bailout the affected financial institutions. Apart from lowering interest rates to the zero-bound, these measures also included credit guarantees and unconventional quantitative easing through direct credit injections, banking reserve expansions, and asset purchases.

The Fed emerged as an effective lender and insurer of last resort. A massive $750 bn financial market bailout was followed by two rounds of quantitative easing. More than $3 trillion have beeen injected into the financial markets to drive Wall Street's recovery. And the results have been spectacular, though confined to corporate America.

Simon Johnson places the recovery in Wall Street and corporate profits in the US in perspective by comparing with recoveries in earlier recessions. The last quarter saw Wall Street back to pre-crisis levels of profits and executive compensation. The bailouts and implicit government guarantees saved the day for Wall Street. The fiscal stimulus backstopped corporate profits from falling too much. The ultra-low interest rates have kept the debt service burdens low and bought time to heal the debt-laden balance seets. He writes,

"Profits for the private sector... in the third quarter of last year... were back at the level of 2006. After the deep recessions of the early 1980s, it took at least three times as long for profits to come back to the same extent."

He also writes,

"In the back-to-back recessions of 1980-82, real non-financial sector profits dropped about 30% (from 1977-78 to 1980) and struggled to rebound for most of the decade. This same measure of profits did not surpass its level of the late 1970s until the early 1990s... during that same cycle... real profits in the financial sector fell 50% from 1979 to 1980, regaining the level of the late 1970s by 1987...

In contrast, over the finance-led boom-bust-bailout cycle of 2007-2010... profits have proved much more resilient. In real terms, the financial sector earned record profits in 2005 (and accounted for an eye-popping 30% of total corporate profits in that year). These fell sharply, to be sure, but only really for one quarter at the end of 2008. Financial sector profits have been running at around 90% of their pre-crisis level since early 2009."

Climate Patriotism Will Only Cause More Problems

Robert Dujarric writes in the Christian Science Monitor that the Obama administration should appeal to patriotism to get Americans motivated to kick the oil addiction. Bush tried this approach back in 2006, but his weak solution was to fund more research (a form of delay) and to prioritize ethanol (which often equates to oil hidden in fertilizers and pesticides, and has unsavory consequences for world food prices).

Dujarric notes that historically in times of war the U.S. government has successfully played the patriot card for various goals: recruiting, war bonds, rationing, etc. Sociologically this argument is dead. America today is a post-sacrifice dreamland. In an economy driven by consumption, there are no costs, only opportunities.

[This is the fluff fed to the American people through marketing, from the bully pulpit (go to war and lower taxes), and by a media that sanitizes the true human experience of war or revolution. (The photos leaked from Abu Ghraib were an exception to this taboo, and the Neda Sultan video a stark intrusion of the Real.) Little wonder our fictional visual media constantly grow more casual, visceral, celebratory, and creative in their depiction of torture and murder. The problem is less that these media motivate violence and more that they are an expression of our repressed refusal to maturely engage the ongoing violence and evil of our world, whether banal or dramatic—poverty, rapes in Congo, strip mining.]

Practically speaking Obama has been reluctant to coax or force people into cutting oil consumption. During the campaign he rejected the idea of raising gasoline taxes, which would have satisfied Dujarric's desire to make life harder for authoritarian petrocrats. And now the administration is handcuffed by the need to stimulate the economy, while the underlying fundamental problem has not been solved: the economy equals pollution. Dujarric rightly notes that the global recession has been the only effective means of slowing emissions.

But the major fault line in his argument is its appeal to a very retrograde expression of patriotism, one based on fear, hate, enemies, and "the other." Gone are the days when we can blanket lump and demonize a "foreign" people to accomplish domestic or international goals. Destabilization of regimes and democracy promotion of this stripe is dead.

If Obama wants to appeal to American patriotism, he should elevate the debate. Americans pride themselves on being the type of people who don't run from their responsibilities. And when you look at current, cumulative, and per capita emissions, Americans bear a lot of responsibility for the current crisis.

Going forward, successful nations will be defined less by whom they confront, and more by what they can construct (and how they share it). This in the end is one symbolic lesson of the falling towers of 9/11: What have we built?

Given the urgency of global warming, the situation has moved past specific battles like saving polar bears to the idea of saving civilization. But this requires that we also be civilized. To achieve this, honesty is the change people have been waiting for, not jingoism.