Austerity policy

Shrinking states – and economies

Economists in Latin America, Africa and Asia are bewildered by Europe’s recent development. The Euro Zone has been trying to escape recession by cutting government spending, shrinking states and liberalising markets. The result has been more recession in many countries, and stagnation in others. Experts in emerging markets and developing countries wonder why the EU is inflicting on itself the policies that failed to work in the context of structural adjustment at the end of the past century.
Job centre in  Cascais: for the age group 15 to 24, the unemployment rate is 35 % in Portugal. Rafael Merchante/Reuters Job centre in Cascais: for the age group 15 to 24, the unemployment rate is 35 % in Portugal.

The triumph of the left-wing party Syriza in Greece in January has added suspense to the economics debate in Western Europe. That debate started when the American financial crisis of 2007 became an international phenomenon, with the failure of the investment bank Lehman Brothers in late 2008.

The crisis spread fast from the USA to the EU. By the end of 2009, GDP had contracted by 4.5 % in the EU, with Ireland, Italy and Germany suffering particularly heavy losses. Of the three econo­mies, Ireland suffered most, because of the weaknesses of its banking system, and soon the country needed a bailout. Then Greece needed a bailout, followed later by Portugal and, still later, by Cyprus.

Other countries, such as Spain and Italy, were in difficulty too. But they managed to avoid the appeal for formal bailout schemes. Spain, however, required other kinds of support than a formal bailout.

In this context, austerity policies were revived. The idea was that excessive government debt was at the root of the problems. Internationally, most economists thought this approach had been buried by the so-called Keynesian revolution of the 1930s (see box below). Europe, however, opted for austerity none­theless.

The bailouts were organised by a troika, an ad hoc grouping of representatives from the European Commission, the European Central Bank (ECB) and the International Monetary Fund (IMF). Countries in need of finance had to accept conditionalities to get loans. They had to make commitments to cut fiscal deficits, by both raising public revenues and reducing public spending, and they had to promise to shrink state bureaucracies, privatise public enterprises, reduce social-welfare protection, liberalise labour laws et cetera.

This kind of policy mix is only too familiar to people in emerging markets and developing economies. It resembles the structural-adjustment programmes the World Bank and the IMF imposed in the 1980s and 1990s. In many cases, the economies concerned became overly-indebted instead of more competitive. In the end, multilateral debt became necessary.

In view of that experience, the results of Europe’s austerity are not surprising. According to data provided by Eurostat, the EU’s statistical office, growth has not only been hurt in peripheral countries, but even in countries such as Germany, that are widely considered to be successful in overcoming the crisis.

Austerity was supposed to be a bitter pill at first, but trigger healthy growth soon. In the worst-hit countries, it is hard to argue that it led to anything but more unemployment, more emigration, more poverty, less social protection, less business activity and less political stability. And even though fiscal deficits were reduced, public debt has risen dramatically in all countries concerned. The reason is basically that tax revenues dropped as economies shrank.

Portugal for example

If one examines individual countries in more detail, the picture is absolutely depressing. Portugal, for instance, completed its troika-led adjustment programme in 2014. According to Eurostat, the country’s workforce shrank by about 10 % to not quite 4.5 million people in the years 2009 to 2013. Early this year, Portugal’s National Institute of Statistics (NIS) reported that the unemployment rate had improved marginally to 13.4 %, but was almost 35 % for the age group 15 to 24.

One must bear in mind, moreover, that unemployment rates can be misleading because they do not include people who have given up looking for jobs. According to the NIS, the share of economically active people in Portugal was back to the level of 2003 in 2013, considerably below the level of 2009. All progress made in this century’s first decade has been undone.

There is reason to doubt that these welfare losses were the price to be paid for a better future perspective. The outlook remains bleak. Eurostat data is not available for 2014 yet. However, the growth rates that the IMF foresees remain around merely 1.5 % until 2019, and it has not made forecasts beyond that date. More important, after literally collapsing from 2011 to 2013, total investment is supposed to improve a bit after 2014, but the numbers indicated are not even close to the rates necessary to close the gaps that opened up in the crisis and the ensuing austerity period. A host of economic data shows that Portugal is not set to return to the prosperity it knew before the financial crisis.

Continental exception

So why have these policies been adopted? And why have their sponsors kept insisting on them even though cost-benefit analyses show that they are not working? An important reason is that many economists in continental Europe, and especially Germany, do not subscribe to Keynesian theories as their colleagues in many other countries do.

One reason is that they tend to identify Keynes­ianism with the interventionist postures of the Nazis. Moreover, Joseph Schumpeter and Friedrich August von Hayek, two prominent Austrian pre-war economists, remain very influential. Both emigrated in the Nazi years. From Schumpeter, austerity supporters take the idea that competition and innovation are decisive for the advance of capitalism, and they believe both to be stifled by Keynesian state interventionism. Hayek’s legacy is the assumption that, no matter how big market failure may be, government failure is probably even bigger.

Herbert Giersch was an influential German post-war economist. According to him, Keynesian policies thwart the market incentives that drive competition, innovation and labour productivity on the one hand and impose wage discipline on workers on the other. In this view, public expenditure will basically stimulate rent-seeking behaviour, the attempt to benefit from government favours rather than to prevail in market competition.

Moreover, German economists argue that excessive government spending means that inflation will sore and taxes must rise. Basically, the proponents of austerity argue that competitive pressure is the only way to promote prosperity, so any government intervention in a market is bound to fail.

The weak link in such reasoning is that competitive pressure does not always drive innovation and productivity. Keynesians insist that there is no incentive for innovation when there is only insufficient demand for goods and services. If a private-sector company cannot sell its current output and expects the market to stay depressed, it has no reason to invest in its capacities, some of which are idle, after all. Keynesians point out that firms invest only when they expect to sell their goods and services with a profit – and that is not what they expect when markets are depressed.

Austerity proponents fail to answer the question of who will buy the additional output. Their policies ultimately add up to a neo-mercantilist strategy: the only way forward is to export goods. If insufficient demand marks domestic markets, greater productivity will only make sense if companies can sell goods and services abroad.

Zero-sum exports

The problem is that this strategy cannot work for all national economies at the same time. It is an arithmetical truth that net exports cannot rise for every country. For some to be net exporters, others have to be net importers.

Germany has obviously prospered for decades by raising productivity and performing impressively in world trade. For policy makers of a country that exports a huge share of its GDP, as Germany does, this strategy may seem to have no alternative. What has worked for a highly dynamic nation of some 80 million people, however, cannot work for the entire EU with 500 million people. The EU is plainly too big to escape crisis via exports.

Indeed, the experience of the past five or six years has not vindicated austerity. Rather, it shows the need to revive demand. Some countries, notably Germany, have been able to attenuate the effects of the crisis by expanding net exports. However, even they are short of breath when the international economy reduces its pace, as it is currently happening. And who will they sell their products once all other economies are as competitive as they are?

Today, growth is subdued everywhere in the EU. Even in Germany, the lack of investment is a matter of great concern. Countries like France and Italy are struggling. Formerly successful economies, like those of the Netherlands and Finland, look stuck in downward spirals. Moreover, the ECB warns that Europe may be sliding into deflation, which most economists consider to be more dangerous that the inflation European policy makers fear. The reason is that deflation compounds economic depression as prices drop, further reducing the hope to sell products with a profit.

No longer a global example

People in Europe have endured sacrifices for years. The results are meagre in terms of growth, employment and investment. Poverty has increased. Phenomena that used to be associated with the developing world – like malnutrition, extreme poverty and mass emigration – have returned to a continent which seemed proud, in the recent past, to have eliminated them. In this context, the rise of extremist parties like the Front National in France is scary, but not at all surprising.

Seen from Latin America, Europe’s recent decline is depressing. The EU used to be a paradigm of economic success combined with welfare-state security. It seems ironic that the USA, traditionally the champion of free markets, used the global financial crisis to introduce universal health coverage under President Barack Obama, while the EU has basically been dismantling the social protection that made it something of a global model.


Fernando Cardim de Carvalho is a professor of economics at Universidade Federal do Rio de Janeiro.

Related Articles


Achieving the UN Sustainable Development Goals will require good governance – from the local to the global level.


The UN Sustainable Development Goals aim to transform economies in an environmentally sound manner, leaving no one behind.