Are Keynesian Expansionary Policies a Better Alternative to Get Europe out of Recession in Europe - Research Paper Example

The austerity measures imposed in Europe: Are Keynesian expansionary policies a better alternative to get Europe out of recession? Proposal In the aftermath of US Subprime crisis and European financial crisis, the governments have been forced to revisit their economic policies with a view to enforce strict discipline in bringing down the expenditures. The efficacy of the financial discipline sought to be achieved by the austerity measures either already introduced or proposed to be introduced depends upon its acceptance at the ground level. If the austerity measures mean decrease in personal income, the individuals’ indifference to financial discipline would make the measures ineffective and in fact counter-productive. Therefore in order to achieve the intended results in this mission, cooperation of the people all levels in implementation of the measures is essential. Austerity measures involve cuts in spending and increase in taxes. However, bringing down the level of expenditure is fraught with several serious consequences and such strategy could push the countries deeper into recession. Therefore, it is proposed that the macroeconomic policies aiming at expanding money supply, increasing government spending and reducing tax rates in appropriate mix should be implemented to ensure economic growth. Keynesian expansionary policy should be considered as an alternative to prevent the countries slipping into deep recession and unemployment situation considering the barriers in introducing and implementing the austerity measures and their adverse effects on economy. Fiscal policies of the government Austerity measures prescribed across Europe to deal with the financial crisis largely talk about government spending. Over the period of time the proportion of non-plan expenditure in the national budgets has been steadily increasing with corresponding decrease in plan-expenditure. Government spending in relation to revival of economy refers to plan expenditure or spending on developmental projects with a view to generate employment and not the administrative expenses of the government or salaries of the government employees. However, austerity could mean any cut which include expenditure on social welfare, job cuts and even increase in tax rates. Associated press reported “Greece, one of three eurozone nations to need an international bailout, has cut spending on just about everything it can – public sector salaries, pensions, education, health care and defence. As a result, unemployment has soared to over 21%, fuelling social unrest that has sometimes turned deadly. In the last two years, riots have erupted frequently and the countrys near-daily strikes and demonstrations have shut down schools, airports, train stations, ferries and harmed medical services.” This is not the intended outcome of the austerity measures whether in the short run or long run and hence there is no fundamental justification for the austerity measures where ad-hoc-ism and discretion play a greater role rather than economic principles. Taxation and government spending are the important tools relating to fiscal policies of the government. Monetary policies of the Central Bank The central banks of most of the countries are independent statutory bodies regulating the money supply in economy and interest rates with a view to keep inflation under control and regulate economic growth. During economic slowdown increase in money supply and decrease in interest rate pushes up demand in economy. European Central Bank (10) stated “As regards the ECB, in the face of financial crisis, monetary policy was eased significantly through conventional means in late 2008 and early 2009, with key interest rates being reduced significantly.” But the imbalances in inflation within the Eurozone have made the adjustments difficult. ECB (29) stated further “Monetary aggregates are at the heart of the ECB’s monetary analysis. Currently, they are used only for cross-checking and to capture the longer-run aspects of monetary policy. The underlying rationale is the quantity theory of money, which states that a prolonged increase in the money supply will translate into an increase in the price level in the medium and long run (given a constant level of money velocity).” It is also important to note that decrease in interest rates will affect the pensioners greatly since the pension funds are mostly invested in the fixed income securities whose returns are correlated with the bank rate. The expansionary policies to be pursued by the governments could be strengthened by appropriate adjustments made by the central banks in monetary policies. Credit growth in banks is an important indicator in an economy which reflects credit off-take by the businesses and industries for expanding facilities for manufacturing or services, establishing new facilities or replacing the existing facilities with modern facilities. Credit off-take in a country depends upon several factors of which increase in demand for the products and services plays a major role. In the absence of fresh investments, economic growth will be stifled and employment generation in the country will be severely affected. Adequate supply of money at reasonable interest rates is an important factor which facilitates fresh investments by the entrepreneurs. Therefore, aggressive austerity measures implemented in this situation, as it will lead to curtailing of consumption, would send wrong signals to the business community and whose long term plans would be downsized due to uncertainties in the economy and lack of support from the government. This would make the situation still worse from the angle of competitiveness of the affected European countries in the world markets. The foreign direct investments which are very crucial at this juncture would dry up leading to stagnation in the economy for a very long time in future. Current Account balances The important countries which have been most affected by financial crisis in Europe are Greece, Portugal, Italy and Spain. The movement in current account balances of these countries over years are given in Annexure-II to V. (Trading Economics) Due to globalization and privatization drive in the developing countries the competitiveness of the products of these countries in the world market has eroded over the period of time which is reflected in the consistent negative balances. Comparison of these balances with that of China (Annexure-VI) reveals lack of any meaningful strategy adopted by most of the European countries during the years mainly due to complacency. The market economies of European countries have the self adjusting mechanisms. For example, if the imports become costlier demand for imports will come down thereby equilibrium in the balance of payment position is restored. However, active intervention on the part of the government to keep it under control is essential. A shift in consumption pattern orchestrated by the government would have improved the balance of payment position of these countries. However, expenditure cut at this juncture would only reduce the proportion of the consumption of indigenous products in total consumption in the country which will further affect economic growth severely. The remedial actions by way of austerity measures are not logical in tackling the real issues involved in slow down and such actions would rather aggravate the economic malady further in eurozone. The financial pressures which are sought to be relieved through austerity measures were borne out of balance of payment crisis. Sinn (3, 4) observed “Until the first breakdown of the interbank market in 2007 there were hardly any noticeable balance of payments imbalances in the eurozone. But then they increased rapidly, showing huge deficits in the GIPS countries (Greece, Ireland, Portugal, Spain). By the middle of 2011 (June), the sum of the accumulated balance of payments deficits (Target liabilities) of the GIPS countries had risen to 327 billion euros. Its counterpart was the sum of accumulated balance of payments surpluses (Target claims) of Germany, which were 337 billion euros by that time.” Lack of following prudent principles in bilateral trade with the other countries and lack of appropriate system for monitoring balance of payments position to intervene effectively to restore the balance in the system has caused the burdens to become too big to carry for long. The rescue packages actually help maintaining inflation at a higher level which erodes competitiveness of the countries in the international markets. Krugman stated “Europe has had several years of experience with harsh austerity programs, and the results are exactly what students of history told you would happen: such programs push depressed economies even deeper into depression. And because investors look at the state of a nation’s economy when assessing its ability to repay debt, austerity programs haven’t even worked as a way to reduce borrowing costs.” GDP Growth and GDP per capita It could be observed that the GDP per capita of the top economies of the world given in Annexure – I (Trading Economics) that European countries like Italy (18935.05) and Spain (15511.93) are comfortably placed in this regard compared to the emerging economies such as India (837.75) and China (2634.71). The GDP per capita of Greece (12653.44), the most affected economy in the euro zone compared to the emerging economies is not disappointing. Reduction in GDP growth will affect the emerging economies severely than the euro zone countries due to this base effect in GDP per capita. Zero or negative GDP growth will in fact cripple the economies of the developing countries since the consumption pattern in the economy will drastically alter the economic situation affecting its growth. However, European countries are in a better position to withstand such slowdowns since the consumption pattern of the people will not change significantly due to high GDP per capita base. Multiplier effect The increase in government spending and decrease in tax rates set in motion a chain of actions in the economy. The employment generation resulting into more consumption leads to increase in demand as well as savings. Savings forms the basis for capital formation to aid developmental process in the country. The private companies establish manufacturing and servicing facilities to meet this demand for products and services which creates further employment. This multiplier effect has its own momentum and the governments need to regulate the economic growth to avoid overheating and keep inflation under control. Tax cuts will increase the deficit assuming government spending at the same level. Increase in government spending will increase the deficit assuming the taxes are maintained at the same level. For example, Full employment capacity of the economy = say 1000 Current level of employment = say 800 Then the Marginal propensity to consume in the country would be 0.75 Value of the multiplier is 1/1-0.75 = 4 The gap would be (1000-800)/4 = 50 The government’s spending for reaching the full employment level would be 50 x 4 = 200. Mankiw (768) stated “each dollar spend by the government can raise the aggregate demand for goods and services by more than a dollar, government purchases are said to have a multiplier effect on aggregate demand.” The purchase from the government raises employment and profits in companies. Increase in earnings by workers results in more spending on consumer goods. The multiplier effect does not stop here. The companies meeting the demands of the consumers step up production and employ more people for this purpose. However, tax cut could result in larger deficit to get the same stimulus compared to increased government spending. This is because a portion of the increase in disposable income resulting from tax cut is saved. Anti-Inflationary policy is the use of fiscal and monetary policies to fight inflation. These policies could be appropriately used when the economy is overheated after prolonged growth which needs to be cooled down by these measures for keeping the inflation under check and regulating the growth of the economy to make it sustainable. In the later phases on stabilization of economy fiscal policy can be used to close the gap by using balanced budget multiplier where spending increase is compensated by an increase in taxes. But, there are political constraints faced by the governments which makes the trade-offs difficult. The current economic situation with austerity measures introduced in some countries has led to a situation called stagflation, where inflation co-exists with stagnation. The governments at this juncture should focus on maintaining the economic growth level without allowing it to get deeper into recession. This cannot be achieved by austerity measures as it will severely impact on employment. Once into recession, the revival will be a very prolonged and painful process for the country. Blinder stated “views on the relative importance of unemployment and inflation heavily influence the policy advice that economists give and that policymakers accept. Keynesians typically advocate more aggressively expansionist policies than non-Keynesians. Recommendations Leijonhufvud (755) stated “Declining investment and increasing saving sounds like a textbook Keynesian recession,” Austerity measures has developed confidence crisis in the businesses and industries due to uncertainties involved in the government actions associated with the austerity measures. Sinn (2) argues “Many European leaders have advocated growth programs for Europes crisis stricken countries, meaning in fact debt-financed expenditure programs. In this note I will argue that such programs are not the right medicine, since the Eurozone suffers from an internal competitiveness problem rather than a temporary lack of demand.” Though this argument confirms the issue of competitiveness, it is against the Keynesian expansionary policies as better alternative to get Europe out of recession. However, the crux of the issue is with regard to the advisability of pursuing austerity measures as a policy to tackle the financial turbulence. Having analyzed the reasons for its unsuitability in this regard the options for maintaining or revival of economic growth depend on fiscal policies of the governments and the monetary policies of the central banks of the countries. Considering the governments’ inability to intervene effectively in the backdrop of adverse balance of payments position, very high Debt to GDP ratio - Italy 127.1, Spain 88.4, Greece 161.6 and Portugal 120.6 (Trading Economics) and accumulated budget deficits expansionary activities in a massive scale is neither possible nor advisable. However, since the government spending is expected to have significant impact on demand, consequently economic growth, it could be regulated without cutting down to avoid negative economic consequences. In the mean time the governments should explore the ways to increase spending selectively to propel economic growth without increasing inflationary pressures further. The tax rates could be selectively fine tuned to encourage shift in the pattern of consumption for reducing the negative impact on current account balances. Conclusion This vicious circle arising out of recurring balance of payment crisis and subsequent bailouts need to be broken by pragmatic fiscal and monetary policies. Spending needs to be stepped up to maintain the growth levels without increasing taxes. At the same time monetary policies should aim at sucking the excess money supply in the economy to arrest inflation. Capital formation is an important determinant in the economic growth and therefore incentive for savings should be made very attractive for the people to save more. This will ensure stability in the economy. The increase in interest rates will lead to slackness in credit growth in the banking sector which is linked to the industrial growth of the nation. However, if taken as a balancing decision by the monetary authorities, this should be compensated by encouraging foreign direct investment (FDI). The FDIs will also reduce the pressure on balance of payments position considerably and act as a catalyst for investments by private companies in the projects related to FDIs in the country. References Blinder, Alan, S. Keynesian Economics, Library of Economics and Liberty, 2008. Web. 24 March 2013 European Central Bank, The Greater Financial Crisis, 20-21 May 2010. Web. 24 March 2013 Krugman, Paul. Europe’s Economic Suicide, The New York Times, 15 April 2012. Web. 24 March 2013 Leijonhufvud, Axel. Out of the corridor: Keynes and the crisis. Cambridge Journal of Economics, 2009, 33, 741-757. Mankiw, N. Gregory. Principles of Economics, Sixth Edition, South-Western Cengage Learning. Mason, USA. Sinn, Hans-Werner. The European Balance of Payments Crisis, CESifo Forum 2012. Sinn, Hans-Werner. Austerity, Growth and Inflation. Remarks on the Eurozone’s Unresolved Competitiveness Problem. Center for Economic Studies & Ifo Institute, January, 2013. CESifo Working Paper No. 4086. Trading Economics.Current Account. Web. 24 March 2013 Trading Economics. GDP per capita. Web. 24 March 2013 Trading Economics. Government Debt to GDP. Web. 24 March 2013 Appendices Annexure - I TOP ECONOMIES LAST PREVIOUS HIGHEST LOWEST UNIT REFERENCE FREQUENCY CHART AUSTRALIA 27427.64 26693.71 27427.64 10449.84 USD Dec/2011 Yearly BRAZIL 4803.40 4716.61 4803.40 1448.14 USD Dec/2011 Yearly CANADA 25933.29 25588.29 26192.94 9374.88 USD Dec/2011 Yearly CHINA 2634.71 2425.47 2634.71 72.32 USD Dec/2011 Yearly EURO AREA 21379.53 21096.43 21808.81 6264.20 USD Dec/2011 Yearly FRANCE 23016.85 22884.95 23584.66 7482.07 USD Dec/2011 Yearly GERMANY 26080.52 25329.32 26080.52 11858.58 USD Dec/2011 Yearly INDIA 837.75 822.76 837.75 180.86 USD Dec/2011 Yearly INDONESIA 1206.99 1143.83 1206.99 194.43 USD Dec/2011 Yearly ITALY 18935.05 18601.38 20000.52 5819.18 USD Dec/2011 Yearly JAPAN 39578.07 39309.65 40707.00 7117.79 USD Dec/2011 Yearly NEW ZEALAND 14646.00 14629.00 15392.50 8042.68 USD Dec/2011 Yearly RUSSIA 3052.15 2923.14 3052.15 1510.54 USD Dec/2011 Yearly SOUTH KOREA 16684.21 16372.50 16684.21 1109.86 USD Dec/2011 Yearly SPAIN 15511.93 15458.21 16369.13 3715.88 USD Dec/2011 Yearly SWITZERLAND 38059.75 37666.39 38240.75 18970.15 USD Dec/2011 Yearly TURKEY 5740.64 5348.57 5740.64 1556.00 USD Dec/2011 Yearly UNITED KINGDOM 28032.79 27321.13 28928.94 10479.68 USD Dec/2011 Yearly UNITED STATES 37691.00 37330.00 38699.01 14091.08 USD Dec/2011 Yearly Annexure - II Annexure - III Annexure - IV Annexure - V Annexure - VI Read More