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Austerity and Economic Potential

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By Peter G. Hall *  
Vice-President and Chief Economist Export Development Canada 

Among the top topics in the global economy’s four-year funk is public finance. First, it was about the fabulous stimulus programs – for size, synchronization and speed, spending like this had no historical peer. Not long after came what seemed like an ideological flip-flop, with virtually the same cast of world leaders preaching austerity. Now, number-crunchers are telling us that cutbacks will bleed the economy for long enough that trend growth will be permanently lower. Is that truly the future we face?

It’s hard not to be gloomy about the situation. When it comes to austerity, no region of the world grabs more headlines than Europe. Collectively, its cutback programs have effectively plunged the region into recession: amounting to 1.1 per cent of GDP this year, European austerity roughly equals estimated annual potential growth for the Zone. Europe’s actions raise the interesting philosophical question as to how the public spending potion quickly turned into economic poison.

America’s looming ‘fiscal cliff’ has many wondering if it is on the same path as Europe. Without preventative action, automatic spending and taxation resets will take a 4-5 per cent bite out of US GDP in 2013, making recession in the world’s top economy unavoidable. Few, if any, believe that any US government would allow this to happen, but post-election action will have to be swift to prevent automatic switches from tripping. Assuming success, the tough work for US policymakers lies ahead, leading forecasters to dial back projections of America’s future growth prospects.

Conditions in the rest of the OECD aren’t much different, with most nations facing protracted cutbacks. Large emerging markets are also struggling. Although better armed with fiscal firepower, their stimulus programs are generally a much greater share of GDP than the OECD average. As such, it is more difficult for them to single-handedly sustain growth, given weak external conditions.

Small wonder forecasts are being revised. Cutbacks are deep, they are happening now, they are occurring everywhere, and they threaten to tip the world back into a recession that there’s little policy capacity to get ourselves out of. And from the current vantage point, it looks like we will be in cutback mode for a long time. It all seems to point to gloomier global long-term prospects – or does it?

A few key reasons suggest that recalculations of long term growth are premature. First, austerity is ultimately temporary. Programs eventually succeed, and if Canada’s 1990s experience is a guide, governments usually overdo it and can even end up garnering huge surpluses. Second, a permanent loss of economic growth would require ever-deepening cuts which, aside from programs in key peripheral Eurozone economies, are not in the plans. Third, economies that are already operating well below their potential eventually have to come back. Rediscovery of this growth dynamic almost always comes as a surprise, and helps economies – and their fiscal programs – to turn the corner. More importantly, such a turnaround helps to achieve a badly-needed reset of global expectations.

The bottom line? Recent downgrades to future global growth projections are premature. Economic fundamentals still suggest that long-term growth is the same as we thought it was a year ago. If history is any guide, these pessimistic recalculations are likely one of the surest signs that the world economy is just about to do the opposite, and launch into the next growth cycle.


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