My colleagues at Economics 21 have written a fascinating editorial on how to think about Germany’s economic recovery:
For months, the conventional wisdom had been that the feckless European governments were risking a double-dip recession by prematurely removing fiscal stimulus. In conjunction with a weak banking sector and overly indebted governments at the periphery (Greece, Spain, Ireland, and Portugal), Europe was supposed to be an anchor on global economic growth, not an engine. Why has the German (and broader European) economy sizzled at the same time as the much touted “Summer of Recovery” in the U.S. has fizzled?
The editorial suggests that the German government has rightly emphasized deep structural reforms to enhance competitiveness:
After enduring nearly a decade of slow growth and low inflation, Germany has disinflated its way to an extremely competitive position thanks to painful labor market reforms. The cost of one hour of labor in Germany is now extremely low relative to the economic value added in that hour. Better coordination of public expenditures is not going to erase Germany’s huge competitive advantage in high-end manufacturing.
Moreover, the editorial makes the case that fiscal consolidation might promote economic expansion:
For more than thirty years, economists have pointed to the “fiscal illusion” on which stimulus depends. Going back to John Cochrane’s formulation, fiscal stimulus depends on households and business being ignorant to, or ignoring the fact that, debt-financed government expenditure eventually requires higher taxes to pay back the borrowing. If businesses and households recognize this and adjust their investment and consumption accordingly, a dollar of stimulus spending could contribute less than a dollar to GDP after accounting for the reduction in private sector consumption and investment. Research has found that as public debt levels increase, the private sector response to additional stimulus is more pronounced. Eventually, the decline in investment and consumption could exceed the positive economic contribution of the stimulus. In these cases, the government can actually increase output by reducing public spending and cutting its budget deficit (see the cases of Denmark, Ireland, Sweden, Canada, and Norway, among others).
To be sure, Denmark, Ireland, Sweden, Canada, and Norway had the advantage of a more favorable global economic climate. The editorial reminded me of The Economist’s special report on Britain’s plans for fiscal consolidation:
If boldness is the test, then the strategy for cutting the deficit cannot be faulted. But though fortune may favour the brave, it can trip up the headstrong. Debate rages—not only in Britain—over whether it makes economic sense to tighten fiscal policy so much, so fast. And austerity plans may not be achievable without ripping vital public services to shreds.
The independent Office for Budget Responsibility (OBR), which now oversees Treasury forecasts, delivered an encouraging verdict in June on the probable economic impact of the budget. Though it trimmed GDP growth forecasts made on the basis of Labour’s policies, from 1.3% to 1.2% in 2010 and from 2.6% to 2.3% in 2011, the downward adjustment was surprisingly small given Mr Osborne’s accelerated fiscal consolidation.
By moving decisively the government has gained credibility with investors worried about Britain’s huge deficit, and yields on government debt have fallen. Moreover, growth was surprisingly strong in the second quarter of this year, with GDP rising by 1.1% compared with its level in the first three months. The worry, however, is that firms and households burdened by debt are in no mood to invest or spend more, and the extra budgetary restraint could choke off recovery. Confidence indicators for both businesses and consumers have dropped since the budget, spurring fears of a double-dip recession.
Fundamentally, we’re making a bet on an uncertain future. I happen to think the British government is making the right choice, given the evidence at hand. But humility is appropriate — and we always need a Plan B.