By Dean Baker
International Relations and Security Network, November 28, 2013

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While it appears that most Eurozone countries and the United Kingdom have finally emerged from their recessions - and the United States appears to be sustaining its recovery - there are no projections that show these economies approaching full employment any time soon. In the case of the United States, the economy has been growing at less than a 2.0 percent annual rate over the last three years, a pace that is not even on a par with its potential Gross Domestic Product (GDP). This means that rather than making up the ground lost in the recession, its economy is falling further behind its potential.

It’s a similar story with the Eurozone countries and the United Kingdom. Growth in the former is virtually certain to average less than 1.0 percent in 2014. The U.K. may do somewhat better, but it is still not likely to make up much, if any, of the ground lost in the downturn. The weak economic performance of these countries should not be a surprise for anyone who remembers their introduction to economics classes. Their economies are essentially responding exactly as the textbook model predicts. With these governments cutting back spending and raising taxes, they are pulling demand out of the economy. This is leading to slower growth and higher unemployment.

At this point it is difficult to understand what other outcome could be expected. With short-term interest rates near zero and long-term interest rates still near historic lows, can anyone really believe that lower deficits can reduce interest rates enough to counteract their contractionary impact? In other circumstances, a lower-valued currency might provide a large enough boost to net exports to offset smaller deficits. But with so much of the world still in a slump, there are not many potential buyers to pick up the slack. Furthermore, a lower-valued currency isn’t a practical option for the countries in the Eurozone.

What’s Japan telling us?

The only route through which deficit reduction can lead to a boost in demand in the current economic climate is by lowering wages and prices, making them relatively more competitive internationally. This is at best a long slog. There is no plausible story whereby it would lead to a substantial uptick in growth any time soon, especially when inflation is already near zero in almost all the wealthy economies.

If any more evidence was needed that the current weakness is simply due to a lack of demand, Japan has graciously offered to provide it. Under its new Prime Minister Shinzo Abe, the country has embarked on a path of aggressive expansionary policy. On the fiscal side it deliberately increased the country’s deficit, spending more money on infrastructure such as disaster mitigation projects, promoting new technologies, and child care. On the monetary side, the Bank of Japan has committed itself to targeting a higher rate of inflation. This means printing as much money as necessary to raise the inflation rate to its 2.0 percent target.

While it is still early to pass any definitive judgment on Abenomics, the initial results look overwhelmingly positive. Growth is likely to be close to 3.0 percent in 2013 and current projections are for growth to average 1.5 percent in the next two years. If Japan’s economy can follow this path it will be the best three-year performance since before the collapse of its bubbles in 1990.

Japan’s success in pursuing expansion, coupled with the dismal track record of the countries pursuing austerity, should be enough to convince any open-minded observer that the path to restoring growth requires more fiscal and monetary expansion. In addition to this sort of casual empiricism there is now a large and growing body of research pointing in the same direction, including work done by the International Monetary Fund.

Falling on deaf ears

Unfortunately, the people who continue to push for austerity policies do not appear open to having their policy recommendations altered by evidence. In this sense they should be viewed as comparable to the creationists in the United States who deny the theory of evolution. Just as there is no amount of evidence that will lead them to question the biblical account of creation and to accept that humans evolved from more primitive life forms, there is no amount of economic research that will change the minds of most proponents of austerity. They believe in this policy for reasons unrelated to economic evidence.

While the opponents of evolution in the United States are a substantial minority, they are not in a position to set national policy on science and education. By contrast, the advocates of austerity seem firmly in control of policy in every major advanced country, with the exception of Japan.

If it proves politically impossible to alter this austerity agenda, then the question is whether there are ways to restore growth in a manner that is consistent with austerity. There are some things that can be done, even if they are very much second best policy.

Practical steps

First, there is a clear advantage to any country that can reduce its price level relative to others. This will increase its competitiveness and boost net exports. Countries with their own currencies like the United States, United Kingdom, and Canada can try to take steps to reduce the value of the currency. However the Eurozone countries don’t have this option since they are tied to a single currency. It is not possible for member states to use devaluation to gain competitive advantage against each other, although they could collectively gain competitiveness against the rest of the world if the European Central Bank were to pursue a low-euro policy.

The preferred route for this sort of “internal devaluation” from proponents of austerity has been to put downward pressure on wages. However this is not likely to be effective or equitable. An alternative would be to put downward pressure on other prices, most importantly land. This can be done through a vacant property tax. The idea would be to impose a tax on property that sits vacant for more than a certain period of time (e.g. 3- 6 months). This would give owners of vacant residential and commercial property an incentive to lower their rents or sale prices.

This could be a substantial boon to depressed economies. Rent is typically 30-40 percent of households’ spending. It tends to be an even higher share with lower income households. If rents can be reduced, it would be the same thing as an increase in the real wage. For example, if tax measures can push down rents by an average of 10 percent, it would be equivalent to a 3-4 percentage point increase in the real wage for most workers.

Landlords may end up losers to some extent, but this would be a genuine redistribution of wealth and/or income from people who are richer, and therefore less likely to spend their money, to people who are more likely to spend. That would be good both from the standpoint of boosting the economy and increasing equity. In addition, a lower price level would help boost net exports.

In the same vein countries can look to ease up their enforcement of patents, copyrights and other forms of intellectual property to the greatest extent consistent with treaty obligations. Prescription drugs alone account for close to 2 percent of GDP in the United States. While they cost less and are therefore a smaller burden elsewhere, there are few countries that could not have substantial savings from pushing drug prices closer to their production costs. This could create some longer term problems for the patent-based system of financing research and development, but this is an inefficient and antiquated system that has long been in need of an overhaul.

It should not be the concern of countries like Spain and Greece that others have wedded themselves to archaic systems of financing research and creative work. If they can push down the price of drugs and other items subject to patent and copyright protection, this would be another way to boost real wages and free up money for domestic consumption.

Finally, countries could look to divide the work they do have more evenly among the workforce. By encouraging employers to reduce work hours rather than workers, the harm from unemployment can be limited. It was not rapid growth that allowed Germany to lower its unemployment rate by 2.5 percentage points since the start of the downturn. Rather it was a set of policies, including a formal work-sharing program that gives employers incentive to keep workers on the job, even if they work fewer hours.

If it does take many more years for most countries to get back to full employment, the pain will seem much less severe if workers remain employed through the slump. Germany has shown that this can be engineered. It would be worthwhile for other countries to try to follow its lead. However, the benefit from this short list of polices is small compared with expansionary macroeconomic politics. If this is kept off the table for political reasons then it is important to look for other options. Remember, it is not the fault of the workers who are suffering that they are unemployed.

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