Fiscal Consolidation and the Future of the Welfare State

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It was often said in the immediate aftermath of the financial crisis that policy mistakes could be forgiven because the situation was so unique. Moreover, since the crisis impacted countries in different ways – early actions in, say Germany or Sweden, were often singled out or criticized in comparison to the economic support measures put in place by the U.S. Part of the international focus on countries like Germany and Sweden had to do with the fact that they actually experienced much deeper recessions than the U.S.

In Germany, the crisis sparked a collapse in output that was driven by a reduction in external demand for its products. In Sweden, it was the opposite, with domestic spending the largest source of the decline in overall output. Yet, their economic recoveries have also been faster and more durable. The Swedish economy expanded 7.3% in 2010, nearly 3-times as fast as U.S. growth. The German economy grew by 4.8% in the four quarters ending March 31, with first-quarter growth accelerating to 6.1% annualized (see chart below in quarterly rates). This growth trajectory appears to be far more sustainable than just a “bounce off the bottom” as many argued was occurring.

Identifying the appropriate fiscal response to the crisis was fairly straightforward for many policymakers around the globe: tolerate large temporary deficits as the result of automatic stabilizers and the decline in tax receipts, but ensure that the numbers add up over the course of the budget window. This sort of policy transparency lets households and businesses know how spending and revenue will be aligned over the medium term, which helps incent the business investment that serves as the foundation of the productivity gains that boost net exports.

In April 2009, Paul Krugman dismissed this line of reasoning, focusing on the global nature of the decline in output: “But there is a problem, that this is a global slump. We can’t all export our way out of it unless we can find a planet to sell to.” Somehow, Germany, Sweden, and other northern European countries managed to find willing purchasers of their goods and their economies have grown rapidly since 2009. Of course, Germany was Krugman’s poster boy of irresponsibility, as its government urged nations to focus on fiscal sustainability rather than Keynesianism in the global 2010 policy battles over austerity.

So, why did these economies take such a conservative approach to fiscal deficits despite much larger recessions than experienced in the U.S.?

Part of the answer, ironically, could be the desire of social democratic politicians in Europe to protect their expansive welfare states. Since the 1980s, the Swedes have recognized the threat fiscal incontinence poses to the generosity of benefits. Eventually, deficits of sufficient size put the welfare state itself on the chopping block. The best way to protect their cherished model is to keep the budget near balance so these types of existential questions are never asked.

As this drama played out in Europe, U.S. policymakers largely ignored this international experience and pointed to all the negative domestic economic data as proof that the problem was much larger than originally supposed. Again, upping the dosage rather than reconsidering the original diagnosis might be understandable if the relative success of the alterative therapy in other nations wasn’t so evident.

The hyperactive fiscal policy response to the crisis here in U.S. included the 2009 stimulus and appropriations bills, extended unemployment insurance benefits, additional aid to state and local governments, and the health care bill. The case for a fiscal stimulus beyond automatic stabilizers remains exceptionally weak. But even if stimulus could be justified by the need to generate consumption to combat the psychological trauma of the crisis, the composition and timing of the Recovery Act was a real problem: nearly $300 billion was designed to be spent after 2010 and nearly $200 billion was transferred to states to keep state and municipal government payrolls well above levels that could be reliably financed without tax increases. These policy errors were repeated in 2010, when an additional $26 billion was transferred to state governments.

Since the policymakers control government outlays and can influence consumption through government staffing levels and unemployment benefits, the simple response to a severe decline in output is to increase direct and indirect government spending. (After all, gross domestic product is the sum of private consumption expenditures, business investment, government consumption and investment, and net exports.) The problem is that increases in government spending have an unknown impact on the consumption and investment decisions of the private sector. Since at least 1974, it’s been clear that some of the increase in government spending is offset by reductions in other private sector outlays. In short, there’s no free lunch: households and business recognize that government spending has to be paid for by someone at some point and tend to put off some investment and consumption to compensate for expected future reductions in disposable income. Indeed, the evidence suggests that the more plausible assumption is that the decline in household and business spending exactly offsets the increase in government purchases. Even if this is not the case, the consumption stimulated is likely to worsen the trade deficit. This is because the boost to consumption causes an increase in imports. This results in some offsetting reduction in GDP even if stimulus has no impact on private sector spending.

Back in Germany and Sweden, their economic rebound occurred with little to no fiscal stimulus. The German budget finished 2010 with a budget deficit equal to 3.3% of GDP after running a surplus in 2008 and a 3.3% of GDP deficit in 2009. The 2011 deficit is expected to decline to 2.5% of GDP, or about one-fourth of the U.S. deficit. The Swedish budget was in balance in 2010 after a 0.8% of GDP deficit in 2009, despite a 5.1% contraction of the economy.

Perhaps the worst part of the fiscal policy experiment run in the U.S. over the last few years is that it occurred just as the country is about to enter a period of rapid acceleration in the growth of the retired population. It’s been clear since the early 1990s that demographics and advances in medical technology were going to combine to produce exponential growth in the cost of government beginning in the middle of this decade. Rather than being in relatively good fiscal health with large amounts of borrowing capacity, the government is entering this period with a public debt load of 70% of GDP and deficits expected to average $1 trillion over the next 10 years.

Although the Obama Administration and Congress won a huge expansion of the welfare state with the health care bill, one wonders whether the cost of this victory is not a more substantial decline in overall generosity of government social insurance. The endurance of Sweden and Germany’s social model is a function of broad-based taxes on consumption that tend to be regressive, but reliably generate revenue. Sweden’s income tax is lower than America’s, thanks to consumption taxes that generate twice as much revenue. The Obama Administration ignores these lessons in favor of proposals to raise taxes on the top 2% of income earners. Conferring benefits on one group that are financed by the income generated by another group engenders an instability that Nordic social democrats would never countenance.

Reporters chronicling the U.S. reaction to the near failure of the largest financial institutions have been quick to note that there were no guidebooks or road maps on how best to deal with a systemic financial crisis because one had not happened since the 1930s. But, this is only true if one either ignores the lessons learned from all the other crises that have occurred around the globe over the last few decades or dismisses those lessons because all these other economies are somehow so different that their experiences aren’t at all relevant to the U.S. situation.

According to the International Monetary Fund (IMF), from 1970 to 2008 there were 124 systemic financial crises across the world. Far from not happening since the 1930s, systemic crises engulfed the world with such regularity that a banking crisis has occurred about once every three months during the entire lifetime of someone who turned 40 last year. The frequency of financial crises and extraordinary societal costs they impose has also – thankfully – led to broad understanding of the optimal policy response to financial crises on both theoretical and practical levels. Analysts who wish to excuse today’s policy errors based on the novelty of the problems are at best ill-informed and, at worst, overly generous to those who’ve committed the errors. Sadly, the longer it takes to set a new policy course in the U.S., the more at risk the welfare state will be in this country.