As Europe descends into a recession, government budgets will fall into deficits. In many cases, the red ink will go deep and rapidly add to piles of sovereign debt that are already high from the recent pandemic.
Growing deficits will put the euro under increased stress, just like it did during the deep recession a decade ago. Back then, the EU, the European Central Bank, and the International Monetary Fund formed what was known at the time as the ‘austerity troika’: they forced the most troubled euro-zone member states to make harsh spending cuts and raise taxes in exchange for cheap loans to their indebted governments.
As I explained in my book Industrial Poverty, the effects of those austerity policies were damaging across the board. Spending cuts and tax hikes escalated recessions into depression-style economic conditions, especially in Spain and Greece. People suffered heavily under mass unemployment, rising cost of living due to higher taxes, and millions of people had to scrape by on dwindling benefits from social welfare programs.
Greece was the worst-hit country of them all. The crisis was so bad there that the country still has not recovered the economic losses inflicted by austerity. The Greek experience from 2009-2014 is one that no other country should have to endure. Yet, without enough attention to where the next recession is leading Europe, governments across the continent will inevitably put themselves and their countries at great risk of repeating that economic disaster.
I wrote this article with the hope of contributing to the prevention of another macroeconomic massacre like the one Greece was subjected to. I hope that we will never again see the kind of supra-national mobbing of a single country like what the EU, the ECB, and the IMF did to Greece.
I will give special attention to the IMF, for one simple reason: their economists made fatal calculation errors that seriously escalated the Greek crisis.
What austerity did to Greece
To understand the IMF’s devastating impact on the Greek economy, it is good to be familiar with some basic concepts of macroeconomics. I provided those in Part I of this article.
The IMF got involved in Greece’s economy in 2010, when they joined the EU and the ECB in demanding that Athens implement a package of tax hikes and cuts in government spending. The goal was to close the deficit gap in the Greek government budget; in exchange for their austerity policies, Athens would receive support for their troubled sovereign debt. The package was presented as if it was all the government needed to do in terms of fiscal policy.
Things turned out very differently. As I explain in “Preventing a U.S. Fiscal Crisis: An Experiment in Political Economy” (Journal of Management Policy and Practice, Issue 1, 2019), a rapid-fire series of austerity packages followed. Depending on how one separates them, the total number was at least ten by 2016.
A list of all the policy measures included in those packages would be too long to reproduce; here is a sample, combined from the aforementioned JMPP article and this piece from the Center for Freedom and Prosperity:
- An increase in the tax on a €40,000 income from 35% in 2009 to 45% in 2016, and a 22% tax on the first €10,000 where previously no tax was levied;
- Cuts in social expenditures from 2009 to 2014 by 15% in family-oriented benefits, 37% in funding for general hospitals, more than 40% in unemployment benefits, more than 45% in health-care benefits, more than 58% in dental care spending, and close to 100% in housing subsidies;
- Substantial increases in the value-added tax, a one-third increase in the fuel tax, among other excise-tax hikes;
- Sweeping cuts in pensions, a 20% reduction in government employee salaries, followed by government layoffs; and
- The closing or merger of more than 2,000 schools.
Again, these are only examples from a long list of tax hikes and spending cuts that the Greek economy was subjected to. While the bulk of the measures was put to work in 2010-2014, austerity policies continued for several years thereafter.
The total effect of these policies was devastating, including a significant increase in the tax burden. From 2009, the year before the austerity policies began, to 2016, taxes increased from 39% of GDP to 50%. This did not help the government’s bottom line: in 2014 the Greek government was collecting almost 10% less revenue than it did in 2009. The budget deficit persisted, especially since spending stayed elevated despite repeated cuts in entitlement programs.
The reason is simple: the drastic austerity measures threw the economy into a tailspin with rapidly rising unemployment and declining household earnings.
According to the OECD, the poverty rate, measured at 50% of national median income and before taxes and transfers, rose from 28.3% in 2008 to 36.6% in 2014. A comparison with the same poverty rate after taxes and transfers—in other words after the welfare state has done its job—pinpoints the reason why government spending stayed elevated:
- In 2008, the Greek welfare state provided benefits that statistically took 16.4% of the Greek population out of poverty;
- In 2014, the welfare state did the same with 21.8% of all Greeks.
These people were added to others who also needed government support. With more people qualifying for social benefits, demand for increasingly stingy support programs outpaced the austerity-driven reductions in benefits levels.
The IMF makes its mistake
Part of the IMF’s role was to provide expert support for the austerity programs that the EU and the ECB force fed the Greek government. A main ingredient in their work was to estimate the effects of austerity measures on the Greek economy. To do so they used careful calculations of the so-called fiscal multiplier.
The multiplier concept is explained in detail in Part I of this article; briefly, it is the rate by which a change in economic activity spreads through the economy. In the case of Greece, the IMF economists calculated how much of a negative impact spending cuts and tax hikes would have on the country’s GDP. These calculations were essential to the sizing and timing of the austerity policies: if the policies were too lenient, they would not lead to the fiscal consolidation—reduction in budget deficits—that the IMF demanded; if, on the other hand, the policies were too harsh, they would cause the economy to decline further.
When the IMF economists advised the Greek government in the early years of the austerity period, they brought with them estimates of the negative multiplier effect from the policies and said ‘this is all the negative impact on your economy that you are going to see.’ Based on their estimates, they thought they had nailed down when the Greek budget deficit would be eliminated.
As it turned out, the IMF economists had gravely underestimated how poorly the economy was going to react to the austerity policies. The loss of GDP and the rise in unemployment turned out to be much worse than the economists had expected. Although the actual estimate is a bit complicated to pinpoint, in essence they missed the mark by 100-150%: if they said that GDP would shrink by 1%, it actually shrank by 2-2.5%.
This can seem like minutia; one percentage point of economic growth here and there can’t make that much of a difference, can it?
Yes, it can, and it did. In 2009, almost 4,460,000 Greeks had a job. Based on the share of GDP that each one of them produced, on average, a 1% reduction in GDP, causing the loss of 44,600 jobs, would have a major impact on government finances. If government takes 39% of GDP in taxes, as it did in Greece in 2009, then each of these job losses costs the government €20,500 in lost tax revenue. In addition, the people who lost those jobs are now eligible for all kinds of benefits from government.
That 1% in lost GDP would deprive government of close to €1 billion in tax revenue. For every 1% decline in GDP that the IMF missed, they missed another increase in the budget deficit they were trying to eliminate. As a result, they had to recommend yet another package of spending cuts and tax hikes.
To the credit of the economists at the IMF, they admitted their mistake. In 2013, they published Working Paper 13/1: “Growth Forecast Errors and Fiscal Multipliers”. Essentially a mea culpa (or perhaps culpa nostra, since there were a group of economists involved), the paper notes that the negative multiplier on austerity policies is much higher when those policies are first implemented than it is when previous austerity measures have already been implemented.
In a nutshell, the IMF economists had found that the first austerity packages that the Greek government implemented had a shocking effect on the economy that subsequent packages did not have. They were confused: in their view the multiplier effect is just a mathematical relationship between two variables in the economy, and mathematical relationships do not change over time.
This is how economists, a.k.a. econometricians, reason about the economy. They fail to see the role that the human mind plays in shaping and changing the economy. Had they done their homework in political economy, they would have known that they were witnessing a classic case of human response to uncertainty. When government first implements austerity measures, i.e., cuts government benefits and raises taxes, people are taken by surprise. It does not help that the measures have been ‘announced’ in advance; when we have not experienced austerity before, we don’t know what the term means for us in our private lives.
For natural reasons, we respond swiftly and forcefully to uncertainty. A first encounter with austerity is an encounter with uncertainty, and uncertainty has an unpleasant impact on economic activity. It makes us want to save as much as we can, and spend as little as possible. That way—to paraphrase one of my economics mentors, Paul Davidson—he who saves his money today will be able to spend it tomorrow.
When people get more accustomed to austerity and learn to anticipate its meaning for their own financial bottom line, they react less violently to it. They can plan their economic activities better. Austerity may cause misery, but predictable misery is better than unpredictable misery.
The IMF economists did not understand this. The reason is simple: they could not then, and likely cannot today, conceptualize uncertainty. Like all cookie-cutter mainstream economists, the IMF economists are stuck in a grad-school imposed world view where all decision makers are rational and possess perfect foresight.
Yes, I am afraid that it is no more complicated than that. This is the explanation of why the IMF made its disastrous miscalculations of what would happen in Greece when their government implemented a barrage of austerity packages.
Devastating the Greek economy
There is another side to the IMF economists’ mistake: Their calculations of how bad things would get failed to take into account the compound effect of the austerity packages. Unfortunately, the Greek people had to learn what that means the hard way. As their government implemented a seemingly unending series of austerity packages, dictated by the IMF, the EU, and the ECB, those packages pushed the Greek economy into a dungeon of economic collapse.
Figure 1 explains just how bad things got. It reports GDP, consumer spending, and business investments (capital formation) per capita. All numbers are adjusted for inflation. The dashed lines represent the level that each variable is in 2022; let us get back to it on the other side of Figure 1:
Figure 1
Sources of raw data: Eurostat (GDP, C, I); OECD (Population)
All these economic variables start declining when the 2009 recession begins. They continue steadily downward, and there is even a slight acceleration in the fall of GDP, all the way to the end of the most intense part of the austerity episode. After that, they remain essentially stable, except for some hiccups around the 2020 pandemic.
The dashed lines, which again represent the per-capita level of each variable in 2022, compare today’s Greek economy to where it was in the past. The comparison is painful: although Greeks in general are doing marginally better now than they did right at the tail end of the austerity episode, they are far from where they were in 2006-2008. Their inflation-adjusted GDP per capita is now at the same level where it was in 2000; private consumption compares to its level in 2001.
As for capital formation, things are even worse: today, businesses in Greece invest at about the same real per-capita level as they did in the mid-1990s.
It is not an exaggeration to say that the austerity episode in the last decade set in motion a de-industrialization of the Greek economy. Hopefully, that will change in the coming years, but as things look right now, Greece is somewhere between a developing and an industrialized economy.
These are only the major economic aspects of what Greece was put through. There are of course other destructive consequences, including an almost wiped-out young workforce. In 2022, there were 246,000 young Greeks in the workforce (aged 15-24), which is about half of the number 20 years earlier. Two thirds of them have a job, which is an improvement over the 40.9% back in 2013.
In 2009, the entire workforce aged 15-64 was 4,950,000 men and women strong. Five years later it had shrunk to 4,736,000, but even worse was the decline in employment: from 87% to 73%. Almost exactly one million Greeks lost their jobs from 2009 to 2014, and things have not improved much since then. With 4 million working in 2022, Greece had about as many people employed as in 1999-2002.
The devastation in Greece has robbed the country of 20 years of economic progress. Taxes are 11 percentage points higher today than they were before austerity: 50% of GDP compared to 39% in 2009. The welfare state remains in shambles, yet people have not been able to build private alternatives to the promises of entitlements and benefits that the welfare state has monopolized—and where it only delivers cents on the euro.
All this, because politicians at the EU believed that it was more important to eliminate the Greek budget deficit than to save the Greek economy; and because economists at the IMF were not properly educated.
Let us hope that no other country in Europe, or else in the world, will ever have to experience what Greece was put through.
