The Greek Protesters May Be Right; For Now, Austerity Is Bad Economics

Although it didn't play particularly well in the avenues of Athens, Greek lawmakers voted for a second round of painful austerity measures on Sunday designed to convince leaders of other European countries to bail out the country before it defaults on 360 billion Euros in government debt.

The deal, hammered out by Prime Minister Lucas Papademos and his coalition government would cut the minimum wage by 22 percent and lay off 150,000 public workers by 2015. In addition, the Greek government agreed to find an extra 325 million Euros in budget cuts by today.

Although serious doubts remain among the Euro countries that the latest 150 billion Euro cash injection can actually save Greece, international stock markets and oil traders were initially buoyed by the possibility the country was on the road to recovery. But in Athens, the people had a different response. Rioting broke out in the streets; buildings were burnt and shops looted. And while it's hard to find an economist who would deny that over the long term Greece needs structural fiscal change to turn around its fortunes, the emotional response of the Greek protesters against the new plan may actually be reflecting good economics - for now, anyway.

In country after country in Europe, where recession has slowed industrial and service sector output and unemployment and falling housing prices have crimped consumer spending, deep cuts in public programs and tax increases to bolster revenue - the so-called bitter pill approach - has been wholeheartedly embraced as the only solution by both conservative and leftwing governments. Problem is, it's looking more and more likely that they're wrong: as a strategy, austerity has by and large failed.

The austerity [imposed] on top of what has happened in the past two years means it is almost mathematically certain that this [Greek rescue] will fail, said Costas Lapavitsas, professor of economics at the University of London. Lapavitsas told the Associated Press that the new austerity plan - a further round, following initial promises of 30 billion Euros worth of budget cuts in 2010 -- could lead the Greek economy to contract by 6 percent this year. If that were to materialize, Greece is finished, Lapavitsas added. There's no way that this debt would be sustainable.

His point is backed up by the experiences of other Euro-zone countries. Take Ireland for example, which implemented a stringent set of austerity measures in December 2010 when the government accepted an 85 billion Euro loan from the IMF and the EU in exchange for budget cuts amounting to 15 billion Euros.

At first blush, it appears that the strategy has worked. Irish unemployment is down slightly to 14.2 percent from 14.3 percent in December, its sovereign bonds have been the best performers in Europe over the past six months and it has avoided recent Euro-zone downgrades by S&P and Fitch.

However, these numbers mask deepening problems for Ireland. The nation's central bank recently said that Ireland's economy is barely breathing and slashed the nation's GDP growth outlook for 2012 to 0.5 percent. And analysts point out that if it wasn't for émigrés, college entrants or people giving up job hunting unemployment would be much higher than current estimates.

Portugal offers an even more disturbing cautionary tale. In May 2011 the debt-ridden country hiked taxes, slashed spending and cut public worker salaries to meet a series of tough fiscal goals required under a 78 billion Euro bailout from the IMF and European Union.

The result? On Monday, Moody's Investor Service cut Portugal's credit rating further into junk after the country's GDP shrank 1.3 percent in the final quarter of 2011, more than double the previous quarter's 0.6 contraction.

And Greece itself has shown that its own austerity strategy, already two years old, has been little help. The country is still on the verge of bankruptcy and on Tuesday the Greek statistics office announced that the economy contracted by 7.0 percent year-on-year in the fourth quarter of last year, following an already unsustainable 5.0 percent contraction in Q3.

But even with evidence that austerity is a dangerous solution when economies are already flagging, this approach is not likely to be reconsidered anytime soon. This is because political imperatives, mostly German, rather than economic logic are driving the austerity agenda.

Put simply, Germany has been on the hook for the lion's share of the bailouts - for example, the country has offered Greece 200 billion Euros in loan guarantees - and the German public is not particularly happy about the nation's treasury being used as a regional bank account. Given that, German Chancellor Angela Merkel must extract strict concessions out of countries that she helps or raise the perception that only the Germans are being asked to make sacrifices.

Indeed, the calls for Merkel to be steely-eyed and even punitive are fanned by German media which has railed against the sight of Greek protestors waving banners blaming Germany for their plight. Germany's best-selling daily, Bild wrote that recipients of German aid, should put flowers outside our embassies and send the chancellor thank-you notes....Instead the demonstrators insult their German helpers and liken our government to Nazis, which is intolerable.

The fact that political considerations are dictating economic policy to the detriment of the most troubled nations has not escaped the attention of some leading global economists. Speaking at last month's World Economic Forum in Davos, George Soros said that Germany is acting as a taskmaster imposing tough fiscal discipline. This will generate both economic and political tensions that could destroy the European Union...and push Europe into a deflationary debt spiral.

Just as scathing were the comments of Stefano Fassina, a top economic advisor to Italy's Democratic party: The Greek riots are just the tip of the iceberg of a failed policy that focuses totally on public accounts and ignores the real economic issues of growth and jobs. The conservative government in Berlin is primarily responsible for imposing this cure. All of Europe is in recession because of it.

For the anti-austerity crowd, China is a poster child for Keynesian, government-supported growth strategies. As the global financial crisis deepened in 2008, rather than tighten government spending, China took the opposite approach and pumped roughly $586 billion into its economy, mostly for public infrastructure, environmental projects, housing and education. In the three years since this stimulus package, the economy has continued to grow, albeit at a slower rate than before the crisis; in January, Beijing announced that the nation's GDP rose by 8.8 percent GDP growth for the fourth quarter of 2011. In fact, China's economy has performed so well that European governments have asked the country to invest some of its foreign currency reserves in the 500 billion Euro bailout fund.

Of course, Greece, Portugal, Ireland and other Euro-zone countries are not China; they cannot count on armies of low wage workers to keep factory capacity at peak levels and multinationals investing billions of dollars to make products for an awakening consumer market. And for that reason, most economists insist that the troubled European countries will eventually have to adopt austerity programs anyway, even if a Keynesian jolt would be better right now. Before long, they will have no choice but to enact tough measures to right their balance sheets. And when they do, these countries will only succeed if they take these policies seriously, said Lawrence Glazer, managing partner at Boston-based Mayflower Advisors.

Glazer argues that austerity and stimulus only work when they are embraced as a consistent strategy and not hesitantly. Essentially both methods could work, it just depends on how far and how hard a country is willing to pursue either, said Glazer. For example, he believes that in time Ireland will come out of its economic malaise, because it is committed to austerity even if it will be harmed by it in the short run. Ireland has a pro-business climate and they want to maintain it, so its economic strategies are seen as in the collective good.

Greece, on the other hand, Glazer notes, will more likely suffer for a long time because it lacks the will to permanently transform its economy. The differences you see between the Greek and the Irish experiences are cultural, added Glazer. For Greece, austerity has been dictated to them and they don't like this.