Austerity and Its Differing Effects on Economic Recovery

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In Project Syndicate, Mark Roe talks about the differing microeconomic fundamentals of Europe as reasons for why austerity has so far been dismal.  The difference between macroeconomics is that we look at outcomes from a large scale where performance is measured in terms of economic growth, inflation, and productivity.  Microeconomics examines how businesses behave based on policies set by government.  In particular, Roe looks at European labor market policies and how responsive firms are to changing market conditions and deficit reduction policies.

If we look back to the U.S. and our last strong expansion of the late 90s, we found drastically different results that arose from deficit reduction.  In 1993, Congress and President Clinton passed the Omnibus Budget Reconciliation Act of 1993 that achieved deficit reduction of $504.8 billion that eventually led the U.S. to achieve budget surpluses in 1998, 1999, and 2000.  A combination of increased tax rates on the wealthy, along with reining the rate of government spending growth, resulted in lower interest rates, which helped form the largest modern economic expansion in the U.S.  While one certainly should acknowledge the role of technology and great innovation, one can attribute the flexible U.S. labor market for deficit reduction leading to strong economic growth and employment rates.

Labor market policies between different countries can be analyzed through looking at the Heritage Foundation’s Index of Economic Freedom.  Specifically, one of their indicators is labor freedom, which they define in terms of the worker and the firm.  With workers, they are not restricted in terms of where they want to work.  For instance, there could be some jobs that require union membership in order to apply for a job.  As for firms, they have the freedom to hire and fire workers at will.  There are some countries that place specific guidelines on firms and their ability to fire workers.  All countries are evaluated with a score ranging from 0 to 100.  A score of 100 means that there are no restrictions placed on workers or firms in obtaining and offering employment.

When comparing the U.S. with European countries, one sees a dramatic difference in labor freedom.  Here is a sampling:

  • U.S.:  95.8
  • Germany:  41.4
  • Spain:  51.8
  • France:  51.6
  • United Kingdom:  71.5
  • Sweden:  54.6

When Roe states that deficit reduction will not work as effectively in Europe as it does in the U.S., he was inferring that Europe’s more restrictive labor policies make firms less reluctant to expand payrolls during economic recessions.  On the other hand, the flexibility within the U.S. labor market make firms more likely to hire when conditions show signs of improvement.  That is one reason why he feels austerity has not worked in Europe.

There are upsides to having more restrictive labor policies, though.  When an economic cycle goes through a downward cycle, U.S. workers feel the brunt of layoffs much more quicker than their European counterparts.  That is one reason why we saw the U.S. unemployment rate spiral at a much higher rate than Europe during 2008 and 2009.  However, the downside is that economic recoveries tend to be slower in Europe than the U.S.


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