The self-defeating contradictions of austerity

Austerity: it’s a nine-letter word that has largely come to define Canada’s fiscal response to the financial meltdown and recession. But for economic policy experts from across the political spectrum, it has increasingly become a four-letter word as many economists and analysts acknowledge austerity is doing more harm than good.

The unprecedented downturn of 2008- 09 threw governments into large deficits. This was not surprising. After all, deficits are created automatically when unemployment rises and incomes and spending decline. Those cyclical deficits are appropriate and even helpful. They assist in sustaining spending power even as the private sector is gripped by recession.

In the initial stages of the downturn, most governments (including in Canada’s) implemented stimulus measures to inject additional spending power into the economy. Those measures were essential in arresting the downturn and fueling an initial year or two of relatively vibrant recovery.

By 2011, however, many governments (again, including Canada’s) had taken their foot off the stimulus gas pedal and slammed it firmly on the fiscal brakes. Significant cutbacks in public-sector programs, employment and investment were engineered, all in hopes of eliminating deficits and stopping the rise of public debt.

However, when the deficit was caused by an economic slowdown, trying to solve it through spending cuts is a self-defeating strategy. Those cutbacks actually add to the underlying economic weakness that caused the deficit in the first place.

At best, austerity swims against a strong economic tide. The savings of every spending cut are partly squandered due to falling income and sales-tax revenues resulting from the loss of public-sector jobs and public programs. At worst, severe austerity can make matters worse by tipping the economy back into recession. That’s exactly what has happened in hard-hit parts of Europe, where it is now universally accepted that severe austerity after 2008 was an enormous policy error.

Proponents of austerity have long touted a balanced budget as a cure-all for a jurisdiction’s economic woes. Economic growth too slow? Slay the deficit and the economy will soar back to life. Job creation tepid at best? Slay the deficit and watch the unemployment rate shrink. Business investment lagging expectations? Balance the budget and entrepreneurs will be clambering over the Ambassador Bridge.

In reality, austerity is more complex and destructive. Advocates of austerity generally dislike public-sector activity at the best of times. They ignore the reality that government programs and employment are important contributors to economic growth. So when government spending shrinks or slows, the broader economy will tend to do the same. Economists call this negative spillover effect “fiscal drag.” It can produce even slower economic growth, slower employment growth and erode the quality of life due to the neglect of essential public services.

According to the most recent Statistics Canada data, government spending on programs and investment at all three levels of government has declined by almost three percentage points of Canada’s GDP since Spring 2009, the peak of the short-lived stimulus effort. The IMF estimates a multiplier effect on government programs of about 1.5, meaning that every dollar in government programs generates a total of $1.50 in GDP, thanks to the spillover and respending effects that are set in motion by government spending. Think of the jobs created, for example, when teachers spend their salaries on basic consumption goods. By this measure, austerity since 2009 has knocked 4.5 points off Canada’s GDP—three points of spending cuts times 1.5, equal to almost one percentage point per year.

Little wonder, then, that Canada’s economy has performed so poorly in the last few years. We’ve been passed by other countries, including the U.S., which have been more concerned with job creation than the pursuit of balanced budgets.

Unless Canadians can convince their governments to change direction, more restraint lies ahead. Ottawa’s program spending stands to shrink by another half point of GDP by 2019. Ontario, meanwhile, is planning on a painful freeze in nominal government program spending, which would cut spending as a share of GDP by almost two points by 2018.

In short, austerity can do more damage than the disease it is trying to cure. The U.S. experience provides an example of how things could have been different. There, the government has tolerated much larger deficits and adopted other unconventional job-creation measures (like quantitative easing in the banking system). Yet the U.S. economy has steadily gained steam in recent years, leaving Canada in the dust. Its deficits are larger and its debt much higher, yet it is creating new jobs at a faster pace, generating new incomes. The deficit is falling rapidly as a happy consequence.

The U.S. has created an average of well over 200,000 jobs per month over the last year. Its economy grew at an annualized rate of five per cent in the third quarter of 2014, far faster than Canada’s. Yes, their deficit is larger. But the government, like Canada’s, can finance those deficits at record low interest rates. If anything, there is a strong case for more borrowing to support infrastructure investment, so long as interest rates are near zero and private business investment remains so sluggish.

Here in Ontario there are finally some hopeful signs on the economic horizon. The lower dollar and the booming U.S. economy will both stimulate demand for made-in-Ontario exports—everything from manufacturing to tourism. Increased production and sales at Ontario firms, along with more and better jobs, will generate higher revenues for the provincial government, revenues that will go directly towards reducing the deficit and paying for the public services all Ontarians rely on.

And Ontario need not rely on economic growth alone to boost revenues. The provincial government should also consider targeted tax measures to reverse the budget cuts of the last two decades. A recent estimate by economist Hugh Mackenzie reveals that in 2013, tax cuts since the mid-1990s undermined provincial revenue by almost $19-billion. Returning the corporate income tax rates to previous levels, or raising gas taxes, perhaps as part of a long-delayed carbon-tax policy, could raise needed funds necessary to support public-sector investment.

The policy and the ideology of austerity have lost considerable traction in the last couple of years. More progressive policies such as infrastructure investment, sustained program spending, and tax measures where necessary would be timely and more effective in addressing both the fiscal and social challenges facing Ontario. As Ontario’s government thinks about how to manage its finances, it would be wise to consider all the options.