Austerity is cool, pre-austerity is cooler!

As everyone debates Italy’s recent bold steps to increase competitiveness (which is a problem in Italy as total factor productivity has in fact being declining – not slowing down – but actually declining since 2006) and cut spending, one ought to remember that austerity measures are a good signal to send to financial markets and investors (its also good for tax smoothing in the longer run). Yet, no one notes that the countries which have applied “pre-austerity” measures actually performed correctly and have been spared the worst of the crisis.

Take Germany, according to a recent IMF publication (Chipping Away at Public Debt by Paulo Mauro), if Germany had preserved its previous policies with regards to competitiveness and spending, it would likely be in a situation as uncomfortable as France or even Italy.  Between the 2001 recession and 2003, the German economy was in a virtual standstill, yet public spending was evolving at a faster pace than revenues, hence worsening the deficit. Interestingly, one should note that the overall balance of the total budgets in Germany as a share of GDP has actually been negative since the early 1970s. So, in 2003, a serious attempt was made in Germany to bring about “fiscal consolidation”. What were the serious reforms?

  1. Corporate tax cuts
  2. Reform of employment insurance (benefits were reduced, shortening duration and admission was made harder)
  3. Pension reform (annual increases in benefits would be reduced if the relative number of pensioners to workers increased)
  4. Reduction in agricultural, construction and coal mining subsidies

Overall, these reforms were modest, but they did enough for Germany to be in the best shape to face the euro crisis and the straight jacket of the euro (where currency devaluation is not an option). But, did Germany balance its budget? Not even, it merely reduced the size of its deficit from around 2.5% of GDP to 1% of GDP. I am not saying that Germany didn’t do good, but even timid steps in good years are wise especially since they allow to smooth tax rates so as to minimize distortions and welfare losses. However, it does seem that politics is not about good economics…


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